Introduction

On July 14, 2015, the Consumer Financial Protection Bureau (“CFPB”) and Department of Justice (“DOJ”) announced they had reached a “groundbreaking settlement” with American Honda Finance Corporation (“Honda”).(1) The settlement resolves allegations that Honda engaged in racial discrimination by charging higher interest rates on auto loans to minority borrowers.

Under the terms of the settlement, the CFPB will not assess penalties against Honda. Instead, Honda will pay $24 million into a settlement fund to compensate minorities affected by Honda’s lending practices between 2011 and 2015. See Consent Order, In the Matter of American Honda Finance Corporation, File No. 2015-CFPB-0014, ¶ 30 (July 14, 2015). Honda also agrees to reduce or eliminate dealer discretion to adjust interest rates for new auto loans. See Consent Order ¶ 26.

Does this mean Honda admits that its lending practices have been unfair and discriminatory? Not at all. On the same day that the CFPB announced the settlement, Honda issued a press release stating that it “strongly opposes any form of discrimination,” and that it “firmly believe[s] that [its] lending practices have been fair and transparent.”(2) Honda also has a “difference of opinion” with the CFPB regarding its methodology used to determine that Honda’s lending practices were discriminatory and harmful to minority borrowers.

Meanwhile, the CFPB has set its sights on another auto lender. Recent news reports indicate that the CFPB is urging Fifth Third Bancorp also to reduce dealer discretion for auto loan interest rate markups.(3)

While auto lenders and others in the consumer finance industry follow these developments, some may be asking whether the CFPB has overreached. Some might also wonder what the Honda settlement portends for the expansion of regulatory oversight of auto lenders. These concerns raise two specific questions. First, what is the legal basis for the CFPB’s supervision of auto lenders? Second, what methodology did the CFPB use to establish the connection between discretion in interest rate markups and racial discrimination in auto lending?

What is the Legal Basis for the CFPB’s Regulation of Indirect Auto Lenders?

The CFPB’s general mission is to “regulate the offering and provision of consumer financial products or services under the Federal consumer financial laws.” See 12 U.S.C. § 5491(a). Notably, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), which established the CFPB, generally prohibits the CFPB from regulating car dealerships. See 12 U.S.C. 5519(a). Specifically, Dodd-Frank states that the CFPB “may not exercise any rulemaking, supervisory, enforcement or any other authority, including any authority to order assessments, over a motor vehicle dealer that is predominantly engaged in the sale and servicing of motor vehicles, the leasing and servicing of motor vehicles, or both.”

The CFPB is, however, tasked – along with several other agencies – with the enforcement of the Equal Credit Opportunity Act (“ECOA”). See 15 U.S.C. § 1691c(a). The ECOA prohibits any “creditor” from discriminating against any loan applicant on the basis of race, color, religion, national origin, sex, marital status, age, receipt of public assistance, or the exercise of a right under the Consumer Credit Protection Act. See 15 U.S.C. § 1691(a)(1). A “creditor” includes “any person who regularly extends, renews, or continues credit” and “any assignee of an original creditor who participates in the decision to extend, renew, or continue credit.” See 15 U.S.C. § 1691a(e). Regulation B provides, more broadly, that a “creditor” includes “a person who, in the ordinary course of business, participates in a credit decision, including setting the terms of the credit” as well as “creditor’s assignee, transferee, or subrogee who so participates.” See 12 C.F.R. § 1002.2(l). The CFPB says that indirect auto lenders are “creditors” under this definition.

On March 21, 2013, the CFPB issued a bulletin providing guidance on indirect auto lending and compliance with the fair lending requirements of the ECOA and Regulation B.(4) In the bulletin, the CFPB warns that when car purchasers seek financing for an automobile purchase from the auto dealer, which in turn facilitates indirect financing by a third party, that lending is subject to regulation and potential liability.

In the bulletin, the CFPB states that, “[e]ven as assignees of the installment contract, indirect auto lenders are creditors under the ECOA and Regulation B if, in the ordinary course of business, they regularly participate in a credit decision.” For example, the CFPB found that an indirect auto lender is probably a “creditor” if “it evaluates an applicant’s information, established a buy rate, and then communicates that buy rate to the dealer, indicating that it will purchase the obligation at the designated buy rate if the transaction is consummated.” The CFPB also indicated that an indirect auto lender is likely a “creditor” when the lender “provides rate sheets to a dealer establishing buy rates and allows the dealer to mark up those buy rates” if the lender later purchases a contract from that dealer. Most importantly, the bulletin states that “[a]n indirect auto lender’s markup and compensation policies may alone be sufficient to trigger liability under the ECOA if the lender regularly participates in a credit decision and its policies result in discrimination.”

Just a few months after the bulletin, the CFPB ordered Ally Financial Inc. and Ally Bank (“Ally”) to pay $80 million in damages to harmed minority borrowers and $18 million in penalties.(5) See Consent Order, In the Matter of Ally Financial Inc. and Ally Bank, File No. 2013-CFPB-0010 (Dec. 20, 2013). The CFPB had begun an investigation in 2012, and found that Ally violated the ECOA by charging African-American, Hispanic, and Asian and Pacific Islander borrowers “significantly higher dealer markups for their auto loans than similarly-situated non-Hispanic white borrowers.”

Finally, the CFPB expanded its regulatory oversight of indirect auto lending by the issuance of a final rule, under Dodd-Frank, to supervise nonbank auto lenders. Prior to the rule, the CFPB’s authority reached large banks and credit unions that originated automobile loans and leases, but the nonbank lenders were not yet supervised at the federal level.(6) But under the new rule, the CFPB now has the power to supervise nonbank automobile financing companies (except for auto dealers) that originate 10,000 or more loans per year.(7)

The New York Times editorial board praised the new rule, calling it a “regulatory breakthrough.”(8) The editorial board criticized “hidden finance charges” and dealer discretion to quote higher interest rates to a borrower because “[t]his discretion has led to minority borrowers paying higher interest rates than white borrowers with similar credit histories.” The analysis naturally turns, then, to how the CFPB came to the conclusion that dealer discretion for markups causes discrimination against minority borrowers.

How did the CFPB Conclude that Discretion in Interest Rate Markups Harms Minority Borrowers?

Although the CFPB is charged with ensuring that lenders comply with fair lending laws, the CFPB sometimes lacks key information for its analysis. In the context of auto lending, borrowers do not provide information on their race or ethnicity. How can the CFPB ensure that lenders are not discriminating against minorities when it does not know which borrowers are minorities?

To address this dilemma, in the summer of 2014 the CFPB released a white paper titled, “Using publicly available information to proxy for unidentified race and ethnicity.”(9) In that report, the CFPB states that “substitute, or ‘proxy’ information is utilized to fill in information about consumers’ demographic characteristics.” According to the CFPB, researchers and statisticians often rely on “publicly available demographic information associated with an individual’s surname and place of residence from the U.S. Census Bureau to construct proxies for race and ethnicity when this information is not reported.” Thus, although a borrower does not report his or her race or ethnicity to the auto lender, the borrower’s home and last name provide a certain probabilities as to the borrower’s race or ethnicity.

The CFPB does not view these two pieces of information in isolation. The CFPB’s Office of Research (“OR”) and Division of Supervision, Enforcement, and Fair Lending (“SEFL”) have combined geographic location and surname information into a single probability analysis called the Bayesian Improved Surname Geocoding (“BISG”). The CFPB’s white paper concludes that “the BISG proxy probability is more accurate than a geography-only or surname-only proxy in its ability to predict individual applicants’ reported race and ethnicity and is generally more accurate than a geography-only or surname-only proxy at approximating the overall reported distribution of race and ethnicity.”

Prior to its settlement with Honda, the CFPB conducted a joint investigation with the DOJ of Honda’s indirect auto lending activities and its compliance with ECOA and the ECOA’s implementing regulation, Regulation B. See 15 U.S.C. §§ 1691-1691f; 12 C.F.R. pt. 1002.

According to the July 14 Consent Order, “[t]o evaluate any difference in dealer markup, the [CFPB] and the DOJ assigned race and national origin probabilities to applicants” using the BISG method. See Consent Order ¶ 16. The CFPB then used the race and national origin probabilities obtained through BISG “to estimate any disparities in dealer markup on the basis of race or national origin.” See id. According to the Consent Order issued by the CFPB, the differences in interest rates were based on race and not on any other objective criteria such as creditworthiness. See Consent Order ¶ 18-20.

The CFPB concluded that between 2011 to 2015, on average, African-American borrowers were charged interest rates approximately 0.36% higher than similarly-situated white borrowers, resulting in an average of $250 more in interest owed on the loan for the full term of the contract. See Consent Order ¶ 18. The CFPB also found that Hispanic borrowers and Asian/Pacific Islander borrowers were charged interest rates approximately 0.28% higher and 0.25% higher, respectively, requiring them to pay approximately $200 and $150 more, respectively, for their auto loans. Thus, the CFPB’s fact findings, relying on the BISG method, contradict Honda’s insistence that it acted properly and did not engage in discriminatory lending practices.

Conclusion

Auto lenders and others in the consumer finance industry should pay close attention to the CFPB’s recent actions relating to auto lending, including the CFPB’s issuance of a rule expanding its supervisory authority to include nonbank auto lenders and the CFPB’s settlement with Honda. Two implications seem clear. First, because the CFPB views disparate impact as sufficient evidence of unlawful discrimination in violation of the ECOA, the CFPB likely will continue to pursue indirect auto lenders whose markup and compensation policies appear to result in higher interest rates charged to minority borrowers. Second, although the CFPB is currently prohibited, with few exceptions, from directly regulating car dealerships, the CFPB may use its rule-making authority to further expand the scope of its supervisory authority in the auto lending arena.

Endnotes

1. http://www.justice.gov/opa/pr/justice-department-and-consumer-financial-protection-bureau-reach-groundbreaking-settlement

2. http://news.honda.com/newsandviews/article.aspx?id=8573-en

3. http://www.wsj.com/articles/cfpb-proposes-fifth-third-bancorp-change-auto-lending-practices-1438809888

4. http://files.consumerfinance.gov/f/201303_cfpb_march_-Auto-Finance-Bulletin.pdf

5. http://www.consumerfinance.gov/newsroom/cfpb-and-doj-order-ally-to-pay-80-million-to-consumers-harmed-by-discriminatory-auto-loan-pricing/

6. http://files.consumerfinance.gov/f/201410_cfpb_supervisory-highlights_fall-2014.pdf

7. http://files.consumerfinance.gov/f/201506_cfpb_defining-larger-participants-of-the-automobile-financing-market-and-defining-certain-automobile-leasing-activity-as-a-financial-product-or-service.pdf

8. http://www.nytimes.com/2015/06/14/opinion/sunday/putting-an-end-to-abusive-car-loans.html?_r=0

9. http://files.consumerfinance.gov/f/201409_cfpb_report_proxy-methodology.pdf