Lender liability for merchant misconduct in consumer transactions.

• Author: Forsythe, Ian
• Position: Cover story

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There is a great deal of misconception about whether lenders (including banks, credit unions, and finance companies) are subject to the claims and defenses that a consumer has against a merchant when the lender provides the funds to finance a consumer transaction. This issue arises in a variety of situations involving the use of credit in consumer transactions, and this article will present the more common scenarios and discuss the various reasons why, in most cases, lenders are subject to the claims and defenses that a consumer has against the merchant.

In the first scenario, a buyer purchases a vehicle from a motor vehicle dealer, and finances the purchase by entering into a retail installment contract with the dealer. The retail installment sales contract contains terms upon which the dealer is willing to finance the purchase, including the interest rate, amount of payments, number of payments, and total finance charge. However, before the dealer consummates the retail installment contract with the consumer, the dealer investigates the consumer's creditworthiness and compares it against pre-determined credit standards that are provided to the dealer by banks and lenders. In this way, the dealer attempts to gain some assurance that the retail installment sales contract will be approved for assignment to a bank or lender in exchange for the lender tendering a lump sum payment to the dealer. (1) Assuming the lender accepts assignment of the retail installment sales contract and pays the dealer for assignment of the retail installment contract, the bank or lender (as assignee of the retail installment contract) then advises the consumer to send all payments to the bank or lender.

In the second scenario, the merchant arranges a loan for the consumer by referring the consumer to a lender with whom it has a referral or contractual relationship, and the consumer then obtains a "purchase money loan" directly from the lender to finance the purchase. In this situation, the merchant obtains a financial benefit from the issuance of the loan, either because it has an ownership interest in the lender, or by way of a referral fee, or a commission, or other financial incentive arrangement.

In the third scenario, a consumer finances purchases from a merchant with the merchant's "store brand" credit card. There are two types of store brand credit cards--"private label" and "in house." Most store brand credit cards are private label cards that have the merchant's label directly on the card (e.g., Home Depot), and they can only be used at that particular merchant, but they are actually issued by a bank (e.g., Citibank). "In house" credit cards also have the merchant's logo directly on the card, and they can only be used at the merchant identified on the card, but they are different than private label cards because they are issued by the merchant, and not by a bank. Only a few very large merchants, like Walmart and Target, have the resources to issue their own "in house" credit cards. (2) If a consumer uses a private label, store brand credit card to finance a purchase, then his or her purchase is being financed by a bank, and not by the merchant, and to the extent that the bank asserts that it is not subject to the claims and defenses that the consumer has against the merchant, the principles discussed in this article apply. However, if a consumer uses an "in house" store brand credit card, then the lender and the merchant are one and the same, and the consumer can assert any claims and defenses directly against the merchant.

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In the fourth scenario, and perhaps the most common, a consumer purchases goods from a merchant using a general purpose credit card or other open-ended credit plan where the merchant has no referral relationship with the credit card issuer. The general purpose credit card may include a "co-branded" credit card issued by a merchant that can be used anywhere.

In all of these scenarios, the consumer may later find out that the product was unsatisfactory, or he or she was the victim of fraud, or the merchant failed to honor certain promises related to the sale, or some other wrongful conduct on the part of the merchant. Nevertheless, the lender will insist upon payment, and the lender will usually assert that it is not responsible for the merchant's misconduct. Most consumers feel helpless in this situation because the lender tells them that they have to repay the loan regardless of what the merchant did, and that their obligation to repay the loan is independent of whatever claims or defenses he or she may have against the merchant. In essence, the consumer feels robbed of the only realistic leverage he or she has to force the seller to provide satisfaction--the power to withhold payment. (3)

If payment is not forthcoming, the lender will continue to collect the debt and will report the consumer as delinquent to the credit reporting agencies. If the consumer still does not pay after 180 days, the lender will report the account to the credit reporting agencies as "charged off," and may hire a collection agency, or it may assign the debt to a collection agency. The collection agency will then initiate its own collection efforts, including reporting the same debt again to the credit reporting agencies as a "collection" account (resulting in two separate negative reports on the consumer's credit report). If the consumer still does not pay, the lender or the debt collector may file a lawsuit against the consumer, seeking to recover the amount of the original transaction, plus accrued interest, late fees, court costs, and attorneys' fees.

In all of these cases, the lender's attempt to divorce himself or herself from responsibility for the merchant's wrongdoing is not only fundamentally unfair, (4) but it is contrary to law. That is, despite the insistence of many banks, lenders, and credit card companies to the contrary, in most cases, lenders are subject to the claims and defenses that the buyer has against the seller in a consumer transaction. Before I provide the various reasons why this is true, I need to identify a fourth scenario in which the lender is usually not responsible for the merchant's misconduct. In the fourth scenario, the consumer obtains a loan directly from a lender without...