The primary regulator of consumer financial protection in the US is the Consumer Financial Protection Bureau (CFPB), a federal agency born of the ashes of the last decade’s financial crisis. Racial discrimination did not cause the financial crisis (auto finance securitisations performed well during the crisis), nor is there any evidence to suggest it even played a role. Nonetheless, the CFPB has actively pursued banks and finance companies under the so-called ‘disparate impact’ theory of liability – a questionable legal theory that requires neither direct evidence of discrimination, nor any intent to discriminate.
Disparate impact is a theory of liability that, the CFPB contends, arises from the federal Equal Credit Opportunity Act. The theory requires a defendant to have a facially-neutral policy that has the result of treating protected classes (in this case, racial minorities) less favourably than similarly situated non-protected classes. No discriminatory intent is required; the plaintiff need only show that the defendant’s neutral policy has a statistically measurable negative effect on protected classes. ‘Disparate treatment’ occurs when a policy is discriminatory on its face.
Most auto finance in the US takes place in the dealership, where a dealer sells a vehicle to a customer on credit, then sells the credit sale contract memorialising the transaction to a finance source (generally a bank or finance company). The dealer negotiates an interest rate with the customer, which is based on wholesale rates set by the finance sources. In most instances, finance sources will agree to buy credit sale contracts evidencing retail interest rates up to 250 bps higher than the wholesale rates, and pay the dealer all or part of that difference as compensation for originating the transaction. The crux of the CFPB’s disparate impact allegations is that the portfolios of the banks and finance companies that buy credit sale contracts from dealers show statistical disparities based on race due to the ‘discretion’ finance sources give them to negotiate retail rates with their customers, ie, the policy of discretion allows dealers to charge minorities higher interest rates than non-minorities, resulting in a statistical disparate impact on minorities.
If the concern is that dealers disparately treat minorities, one would naturally wonder why the CFPB would not attack the apparent source – the dealer. Certainly the CFPB would like to go after dealers, but it has learned over the past few years that auto dealers have tremendous lobbying power. Virtually every member of Congress has one or more auto dealers in his or her district, and those dealers are likely long-time contributors to their campaigns, if not close personal friends. Add to that the fact that dealers are probably the single largest contributors of sales tax revenues to their states’ economies, and it’s no wonder they succeeded in convincing Congress in 2010 to deny the CFPB jurisdiction over their activities.
Barred from attacking dealers directly, the CFPB has instead chosen to attack the century-old credit sale business model by holding the finance sources responsible for statistical disparities in their portfolios (which consist of credit sale contracts not from one dealer, but from thousands of dealers across the country). Individual dealers’ retail rate-setting policies vary, and finance sources have no control over the rate variances that ultimately find their way into their portfolios, short of setting the retail rates themselves and eliminating dealers’ ability to negotiate rates with their customers. Even then, statistical disparities will arise because rates don’t remain static, nor are they consistent across the country.
Since 2013, the CFPB has settled allegations of disparate impact discrimination with four major auto finance companies: Ally Financial ($98m) (£69.2m), American Honda Finance Corporation ($24m), Fifth Third Bank ($18m) and Toyota Motor Credit Corporation (up to $21.9m). It has engaged in some settlements with banks it supervises as well, but those were part of the non-public examination process and little is known about them other than general supervisory information periodically published by the CFPB.
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All of the dollar amounts are restitution to be paid to minority consumers for allegedly having paid higher prices for credit, except for $18m of the Ally settlement, which is a civil money penalty paid to the CFPB. The CFPB supported its claims using the ‘Bayesian Improved Surname Geocoding’ (BISG) proxy method, which uses geography and surname to form a single proxy probability for race and ethnicity. The BISG proxy method never determines the actual race of an individual, just a statistical probability of the individual’s race. How high the probability is determines who gets restitution under the CFPB’s orders. The challenge is determining which consumers to pay, since the finance sources have no idea whether a given individual is actually a minority. It’s ironic, to say the least, that it is illegal in the US to inquire as to a credit applicant’s race in an auto finance transaction, yet that is exactly what the CFPB would have finance companies do after the fact to remedy this ‘harm’.
The largest disparity in the four public cases was 36 bps, or less than the cost of a cup of coffee at Starbucks each month. None of the companies admitted to discriminating – it’s impossible to admit to something that you don’t control – and it’s safe to assume that these companies settled the claims to forgo a protracted legal battle with a government agency armed with an enormous bank account.
One can argue the merits of the government’s case against the auto finance industry. In fact, the CFPB’s own documents reveal that its attorneys felt that there was a significant litigation risk in the Ally case that might not go well for them (the documents further reveal that the CFPB felt it could go forward because it had leverage over Ally, which needed government approval to obtain financial holding company status – a designation necessary for it to continue two unrelated lines of business). That risk has only been exacerbated by a recent Supreme Court decision that placed substantial limits on the disparate impact theory, and a scathing report from the Republican staff of the House of Representative’s Committee on Financial Services that exposed in detail the flaws with the BISG proxy method for determining race (not to mention the Committee’s publication of thousands of internal CFPB documents outlining the CFPB’s efforts to upend the auto finance market).
A brave finance source that chose to fight the CFPB’s discrimination allegations might very well prevail, sounding the death knell for the disparate impact theory in auto finance. The question is whether it’s prudent to wage the battle when you might create a war with your regulator for years to come.
Michael Benoit is chairman of Hudson Cook LLP and a partner in the firm’s Washington, D.C. office