Third Interim Report on Cost of Credit Disclosure Act 1994


Part 2 -- Charges and Calculations

Section 7 Permitted disbursement charges

One commentator asked whether life or disability insurance on the loan would be a permitted disbursement charge. The short answer is that optional life or disability insurance would be treated as an optional service, and the premiums would be regarded as an optional service charge, not a non-interest charge. There are specific requirements regarding disclosure of optional service charges in several places in CCDA: see e.g. s. 5, 25(c)(d)(k).

What if the insurance is not optional, but is a condition of getting the loan? For example, what if a prospective lender requires a borrower to purchase some sort of life insurance to ensure that the loan will be paid off if the borrower dies during the term? The answer depends on whether or not the premium would be payable to the lender or an associate of the lender. If it would, the premium would fall within the definition of a "non-interest charge". But it would not be a permitted disbursement charge. Thus, a requirement to purchase some form of insurance from the lender or an associate of the lender would violate the act.

The situation is different if the lender requires the lender to purchase insurance or any other service from a third party (who is not an associate) as a condition of entering into the loan. CCDA 3.2 does not restrict or require any particular disclosures for such a transaction. CCDA 3.2's failure to restrict or impose disclosure requirements regarding charges of independent third parties is deliberate. It was assumed that the third party would necessarily have to disclose its charges to the borrower in the ordinary course of events. For example, if a mortgage lender requires a borrower to provide a survey certificate at the borrower's own cost, the surveyor who provides the certificate will presumably provide the borrower with a bill for the service. Similarly, it is reasonable for a lender to require a borrower to keep the subject matter of the lender's security interest (e.g. a house or car) insured and it is also reasonable to assume that the insurer (or insurance agent) will disclose the premium to the borrower.

However, CCDA's failure to impose any restrictions at all on payments to third parties is a potentially serious defect that needs to be addressed in some fashion. The following scenario illustrates the potential problems.

A lender (L) offers second mortgage loans at very attractive rates: lower than the prevailing rates on first mortgages. However, prospective borrowers (B) soon discover that they cannot obtain one of these loans without buying and paying for "default insurance" from a particular provider of such insurance (U). L is the beneficiary of this insurance, for which the premium paid by the borrower is typically 5% of the initial loan balance. If B defaults, U will pay the outstanding balance but will be subrogated to L's rights against B. U is not an associate of L, but pays L a "referral fee" for each borrower who buys this default insurance.

The preceding is a worst case scenario that illustrates several problems with the existing gap in CCDA's requirements:

1. Essentially, B is paying U to assume the risk that B will default on the loan, a risk that normally would be borne by L and would be reflected in the interest rate. Unlike the types of expenses that are meant to be covered by a flat charge, "risk cost" does vary with the amount of the loan and the length of time it is outstanding. Obviously, the main reason why the interest rate is so low is that a substantial portion of the loan cost that would normally be reflected in the interest rate has been transferred to the premium for the default insurance. It is also worth noting that by converting what is really a charge for the use of funds into an insurance premium that is paid up front, this arrangement will deprive the borrower of much of the benefit of prepaying the loan (unless some provision was made for a partial rebate of the premium upon prepayment of the loan).

2. Although the premium is not paid directly to L, and thus is not caught by the current draft, the "referral fee" is in substance a payment from B to L. It increases L's return on the funds it advances. Moreover, the fact that U provides L with this referral fee ("kickback") suggests that the amount of the premiums is set at a level that is intended to do more than cover the risk of default.

3. Not only is B required to buy the default insurance, it is required to buy it from U. This prevents B from shopping for the least expensive "default insurance".

I can think of specific provisions that would address the problems identified in points 2 and 3. However, the fundamental problem is the one described in point 1: the current version of CCDA would give lenders who are inclined to do so a relatively easy method of artificially reducing the interest rate on their loans by transferring a cost that would normally be reflected in the interest rate to a third party and requiring the borrower to pay the third party to accept those costs. One method of dealing with this problem would be to insert a provision in CCDA along the lines of "Section 6.1", which follows:

6.1 Payments to third parties by borrower

(1) A lender must not, as a condition of extending credit, require a borrower or prospective borrower to purchase any product from or make any payment to a third person except in the circumstances described in subsection (2).

(2) A lender may require a borrower to purchase a product from or make a payment to a third person if

(a) the object of the loan agreement is to finance the purchase of that product; [e.g. the house, car, boat or whatever whose acquisition is the whole object of the loan]

(b) the payment relates to a liability to which the borrower would be subject whether or not they entered into the loan agreement; [e.g. property taxes]

(c) it is a product that a reasonable borrower might be expected to purchase if not required to do so as a condition of entering into the loan agreement, and

(i) the lender does not require the borrower to purchase the product from a particular source, and

(ii) the lender does not receive a commission or fee from the supplier of the product;

[e.g. property insurance or life insurance that benefits the borrower, but not default insurance that does not benefit the borrower]

(d) the payment relates to a charge that would be a permitted disbursement charge under section 7(1) if the payment were made to the lender. [e.g. an appraisal fee]

It will be noted that this provision would not affect a lender's ability to offer optional services. It only deals with situations where the lender requires a borrower to purchase some product or make a payment as a condition of obtaining credit. I believe that it would deal with the problems discussed above without imposing undue burdens on lenders. However, it should be recognized that outside parties have not yet had an opportunity to comment on this issue or this particular provision.

Recommendation 9:

The Uniform Law Section should tentatively adopt section 6.1, subject to further discussion with affected parties.

Section 8 Permitted flat charges

Additional Reference: Discussion Notes, Part A.2.b (p. 6)

You will recall (I hope) that one of the fundamental issues discussed earlier in this report was whether lenders should be able to impose a flat charge for fixed loans. Several working group members are strongly opposed to allowing any flat charges for fixed loans. However, CCDA 3.2 would allow a lender to impose one flat charge at the outset of a loan agreement and another flat charge each time the loan is renewed. CCDA 3.2 is identical to CCDA 2 in this respect. However, several commentators have argued that lenders should be able to impose an additional flat charge when a mortgage loan has been paid off and the erstwhile borrower wants the lender to provide a registerable discharge of mortgage. The purpose of the flat charge would be to compensate the lender for the cost of preparing the discharge.

When a commentator on CCDA 2 first suggested that lenders should be able to impose a flat charge for providing a discharge my reaction was that the lender's cost of preparing a discharge when a mortgage loan has been paid off must be very small. After all, it must be readily apparent to a lender whether a loan has been paid off or not; if it has been paid off, the word processor does the rest. In any event, if there are significant internal costs involved in preparing a registerable discharge, they can be taken into account in the initial flat charge. The lender cannot know exactly how much it will cost to prepare a discharge 20 years down the road, but the current cost of doing so is known and should be a reasonable guide to the present value of the cost that will be incurred 20 years from now.

Not everyone is convinced by the foregoing arguments. Two or three commentators on CCDA 3.2 have reiterated that lenders who are asked to prepare a discharge should be able to charge for doing so. One of these commentators argued that a borrower who has paid off a loan has a common law right to prepare a discharge and require the execute it without charge. However, a borrower who wants the lender to prepare the discharge should be prepared to pay a fee for this service. Another commentator reiterated their earlier point that lenders should be able to charge for preparing a discharge at the time of doing so, because the cost of doing so cannot be known in advance. I am still not convinced that lenders should be able to impose a charge for preparing a discharge of mortgage.

One final point. Alberta's Law of Property Act requires a lender whose mortgage loan has been paid off to provide the borrower, without fee, a registerable discharge of mortgage. I have been advised that Ontario does not have such a provision. I do not know what the situation is in other provinces.

Recommendation 10:

CCDA should not be changed to allow for an additional flat charge for preparing a discharge of mortgage.

Section 9 Permitted prepayment charges

Section 10 Prepayment of non-mortgage loans

A commentator noted that allowing unrestricted prepayment of non-mortgage loans without penalty shifts costs from consumers who prepay to consumers who pay in accordance with the original payment schedule. It is true that allowing unrestricted prepayment of non-mortgage loans is not cost-free. However, these provisions reflect longstanding Canadian policy. Throughout this project we have assumed that Canadian legislators have no desire to depart from this policy.

Section 11 Permitted default charges

A commentator took issue with the exclusion of amounts paid to employees from the amount recoverable as default charges. The commentator wondered why, for example, legal fees paid to an outside law firm could be recovered but the expenses of an in-house lawyer could not be. The commentator noted the difference between the approach of this section and the approach of section 7(3) to "in-house" disbursement charges, and argued that this section should make similar provision for in-house default charges.

The current version of section 11 is modelled on section 11 of the Cost of Borrowing (Banks) Regulations. When the working group met in March, CCDA 3.1 section 11 read as follows:

Subject to any applicable rule or practice of court, permitted default charges are charges that cover specific, documented costs incurred by the lender because of the borrower's default.

This version of section 11 had been supported by most commentators on CCDA 2; however, members of the working group thought that it was too flexible. Thus, the working group favoured the provision based on section 11 of the CBBR.

I have considerable sympathy for the commentator's point. As is the case with disbursement charges, it is difficult to see why, in principle, costs incurred by a lender because of a borrower's default should be treated differently depending upon whether the cost relates to work done by the lender's own employees or to services performed externally. Of course, in many cases it will be easier to identify and quantify a cost when a service is performed externally and billed to the lender than where the relevant work is performed internally. But disallowing all internal expenses arguably goes further than is necessary to ensure that default charges are reasonable, which is presumably the object of a section such as this. On the other hand, requiring that the charges relate to amounts paid to external service providers does not guarantee that they will be reasonable.

Recommendation 11:

Adopt the following changes to section 11, subject to further consultation with interested parties. Firstly, subsection (1) should be modified by the addition of the word "reasonable" at the beginning of each clause. Secondly, subsection (2) should be modified to read as follows:

(2) An amount paid to an employee or associate of the lender may be recovered as a default charge only if the amount relates to legal costs mentioned in subsection (1).

The requirement in the modified subsection (1) that the charges be reasonable would automatically be imported into subsection (2). It will be noted as well that the internal expenses must be "legal costs", not the more general category of costs mentioned in clause (1)(b).

Section 12 Brokerage fees

Clarification

One commentator wondered whether a payment (e.g. a referral fee) from the lender to a broker would be regarded as a brokerage fee to which this section applies. The answer is that it is not intended to be caught. Note that subsection (1) refers to a brokerage fee or charge "imposed on or collected from a borrower". A fee paid by the lender to a broker does not meet this description.

Issue 1

Two commentators made similar points regarding the requirement for the broker to provide a separate brokerage fee disclosure statement. One commentator suggested that getting two disclosure statements relating to the same transaction might confuse many consumers. The other commentator noted that in some cases a broker might not have all the information necessary to do the calculations required by this section, and suggested that the section should allow either the lender or the broker to provide the disclosure statement.

Recommendation 12:

Section 12 should be modified to allow the brokerage fee disclosure statement to be incorporated in the lender's disclosure statement and delivered by the lender to the borrower.

Issue 2

A commentator noted that subsection (3) might adversely affect legitimate brokers who charge a refundable fee. The commentator suggested that perhaps the restriction should apply only to non-refundable fees.

First, it should be pointed out that clause 12(3)(b) is not essential to uniform cost of credit disclosure legislation. Different provinces could deal with this issue in different ways without affecting the essential uniformity of ccdl. On the other hand, quite apart from any "uniformity" considerations the clause does serve an important purpose. The main purpose of not allowing the broker to accept payment of a brokerage fee until the loan is advanced is to ensure that prospective borrowers will only pay a brokerage fee for loans that are actually made. It is certainly not unheard of for prospective borrowers to pay a brokerage fee and never get a loan. The requirement in subsection (3)(b) that the broker provide the brokerage fee disclosure statement on or before the day the borrower receives the initial disclosure statement ties in with the special right given to the borrower by sections 27 (non-mortgage loans) and 28 (mortgage loans). This is the right to back out of the loan and avoid liability for any flat charge or brokerage fee by taking certain steps within two business days of receiving the disclosure statement.

The policy underlying sections 11(3)(a), 27 and 28 might be implemented by means other than the "no fee until funds are advanced" rule. As the commentator suggests, brokers could be allowed to charge refundable brokerage fees. It should be kept in mind, though, that a rule providing for refundable brokerage fees will necessarily be more complicated than a rule that states that a broker cannot require or accept payment of a brokerage fee until the funds are advanced. It would be necessary to describe with considerable precision the circumstances that entitle the borrower to a refund, and there would also be the problem of ensuring that prospective borrowers actually get refunds to which they are entitled.

Recommendation 13:

Clause 12(3)(a) should be left as is, but as an optional provision; different jurisdictions could take different approaches to payment and refund of brokerage fees without seriously impairing uniformity.

Section 14 / 14.1 Rebates and discounts

Additional Reference: Discussion Notes, Part A.3.b (pp. 8-10)

The issue here is how to deal with rebate or low-rate financing ("RLRF") programs. Section 14, which takes the same basic approach as CCDA 2, would not allow rebates or low-rate financing to be offered as alternatives to each other under any circumstances; any rebate given to cash customers would also have to be given to credit customers. Section 14.1 takes the same approach as section 14 where the rebate or discount is offered by the seller of the product or an associate of the seller. However, it would allow a third person (most likely, a manufacturer or distributor) to offer a rebate or low-rate financing as alternatives to each other, provided that certain disclosure requirements were met.

In the recent round of consultation on CCDA 3.2, six commentators addressed this issue. One commentator supported the approach embodied by section 14, on the basis that it would make financing costs more transparent. The other five commentators supported an approach along the lines of section 14.1. One of the commentators observed that "the table as suggested provides a very clear means of communication and still permits consumers to make a reasoned choice."

For my own part, I am not convinced that the approach embodied by section 14 would deprive any consumers of any meaningful choice. Moreover, borrowers who end up prepaying the loan (or refinancing) will almost certainly be better off with the market rate loan that starts off with a smaller initial balance (smaller by the amount of the rebate). As discussed elsewhere, I suspect that RLRF programs are structured so that consumers who take the low-rate financing option could have got the same monetary benefit by taking the rebate, and applying it against a loan at the prevailing market interest rate. The Discussion Notes specifically invited prospective commentators to provide evidence that would show that this suspicion was unfounded, that is, that credit customers might sometimes be better off with the low-rate financing option than with the rebate. The closest any commentator came to addressing this question was in the following observation:

Whether your comment about consumers not being better off under low rate financing is true or not is irrelevant. For whatever reason, today, a considerable number of our customers has chosen to take low rate financing for reasons that are meaningful to them. Why should they be deprived of this choice?

My answer to the question posed by the commentator is found in the Discussion Notes and in previous project documents.

I prefer the approach of section 14, but recognize that there is wide support for an approach along the lines of section 14.1. The table contemplated by section 14.1(5) would provide consumers with a pretty good comparison of the rebate and low-rate financing options. My main concerns about the approach embodied by section 14.1 are as follows:

1. The table does not illustrate the relative disadvantages of the low-rate financing option if the consumer prepays the loan.

2. The table provides information for a representative transaction. The relative cost of the alternatives would be affected by departures in the terms of an actual transaction from those of the representative transaction.

3. Section 14.1(4) deals only with advertising. It does not provide for any special disclosure at the time of the transaction. It may be that the initial disclosure statement for an actual transaction should contain a table such as the one required for advertisements. Such a table would allow the consumer to compare the relative advantages and disadvantages of the two options for the actual transaction.

Reluctant Recommendation 14:

Adopt the approach embodied by section 14.1 rather than section 14. However, the exact requirements should be finalized after further discussion with affected parties.

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