Alston & Bird Consumer Finance Blog

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Affirmative Action in Lending: The Implications of the Harvard Decision on Financial Institutions

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Early this summer, the U.S. Supreme Court’s ruling in Students for Fair Admissions v. President and Fellow of Harvard College effectively ended race-conscious admission programs at colleges and universities across the country. Specifically, the Supreme Court held that decisions made “on the basis of race” do nothing more than further “stereotypes that treat individuals as the product of their race, evaluating their thoughts and efforts—their very worth as citizens—according to a criterion barred to the Government by history and the Constitution.”

In particular, the Supreme Court reasoned that “when a university admits students ‘on the basis of race, it engages in the offensive and demeaning assumption that [students] of a particular race, because of their race, think alike.’” Such stereotyping purportedly only causes “continued hurt and injury,” contrary as it is to the “core purpose” of the Equal Protection Clause. Ultimately, the Supreme Court reminded us that “ameliorating societal discrimination does not constitute a compelling interest that justifies race-based state action.”

In the context of lending, federal regulatory agencies expect and encourage financial institutions to explicitly consider race in their lending activities. While the Community Reinvestment Act has required banks to affirmatively consider the needs of low-to-moderate-income neighborhoods, regulatory enforcement actions over the last few years have required both bank and nonbank mortgage lenders to explicitly consider an applicant’s protected characteristics such as race and ethnicity—conduct plainly prohibited by fair lending laws.

Could the impact of the Supreme Court holding extend beyond education to lending and housing? Will the Harvard decision serve to undercut federal regulators’ legal theories for demonstrating redlining and present a challenge for special purpose credit programs that explicitly consider race or other protected characteristics?

Fair Lending Laws Prohibit Consideration of Race

The Equal Credit Opportunity Act (ECOA) prohibits a creditor from discriminating against any applicant, in any aspect of a credit transaction, on the basis of race, color, religion, national origin, sex or marital status, or age (provided the applicant has the capacity to contract). Similarly, the Fair Housing Act prohibits discrimination against any person in making available a residential real-estate-related transaction, or in the terms or conditions of such a transaction, because of race, color, religion, sex, handicap, familial status, or national origin.

In March 2022, the Consumer Financial Protection Bureau (CFPB) went as far as to update its Examination Manual to provide that unfair, deceptive, or abusive acts and practices (UDAAPs) “include discrimination” and signaled that the CFPB will examine whether companies are adequately “testing for” discrimination in their advertising, pricing, and other activities. When challenged by various trade organizations, the U.S. District Court for the Eastern District of Texas ruled that the CFPB’s update exceeded the agency’s authority under the Dodd–Frank Act. This decision is limited, however, and enjoins the CFPB from pursuing its theory against those financial institutions that are members of the trade association plaintiffs. It is also unclear if the verdict will be appealed by the CFPB.

Despite federal prohibitions, regulators such as the CFPB and the U.S. Department of Justice (DOJ) expect, and at times even require, lenders to affirmatively target their marketing and lending efforts to certain borrowers and communities based on race and/or ethnicity.

Race-Based Decisions Are Encouraged and Even Required by Regulators

CFPB examiners often ask lenders to describe their affirmative, specialized efforts to target their lending to minority communities. If there have been no such explicit efforts by the institution, the CFPB penalizes these lenders for not explicitly considering race in their marketing and lending decisions. For example, in the CFPB’s redlining complaint against Townstone Financial, the CFPB alleged that “Townstone made no effort to market directly to African-Americans during the relevant period,” and that “Townstone has not specifically targeted any marketing toward African-Americans.”

What’s more, if enforcement culminates in a consent order, the CFPB and DOJ effectively impose race- based action by requiring lenders to fund loan subsidies or discounts that will be offered exclusively to consumers based on the predominant race or ethnicity of their neighborhood. In the CFPB/DOJ settlement with nonbank Trident Mortgage, the lender was required to set aside over $18 million toward offering residents of majority-minority neighborhoods “home mortgage loans on a more affordable basis than otherwise available.”

And in the more recent DOJ settlement with Washington Trust, the consent order required the lender to subsidize only those mortgage loans made to “qualified applicants,” defined in the settlement as consumers who either reside, or apply for a mortgage for a residential property located, in a majority-Black and Hispanic census tract. Such subsidies are a common feature of recent redlining settlements, which have been occurring with increased frequency since the DOJ announced its Combating Redlining Initiative in October 2021.

Not only do the CFPB and DOJ encourage, and in certain cases, even require, race-based lending in potential contravention of fair lending laws, but federal regulators also expect some degree of race-based hiring by lenders. This expectation is based on the stereotypical assumption that lenders need racial and ethnic minorities in their consumer-facing workforce to attract racial and ethnic minority loan applicants. In the Townstone complaint, for example, the CFPB chastised the lender for failing to “employ an African-American loan officer during the relevant period, even though it was aware that hiring a loan officer from a particular racial or ethnic group could increase the number of applications from members of that racial or ethnic group.”

Ultimately, all the recent redlining consent orders announced by the CFPB and DOJ impose at least some race-based requirement, which would seem to run afoul of fair lending laws and Supreme Court precedent.

Racial Quota-Based Metrics Used by Regulators

Further, when assessing whether a lender may have engaged in redlining against a particular racial or ethnic group, the CFPB and DOJ, as a matter of course, employ quota-based metrics to evaluate the “rates” or “percentages” of a lender’s activity in majority-minority geographic areas, specifically majority-minority census tracts (MMCTs). Then the regulators compare such rates or percentages of the lender’s loan applications or originations in MMCTs to those of other lenders. For example, in its complaint against Lakeland Bank, the DOJ focused on the alleged “disparity between the rate of applications generated by Lakeland and the rate generated by its peer lenders from majority-Black and Hispanic areas.” The agency criticized the bank’s “shortfalls in applications from individuals identifying as Black or Hispanic compared to the local demographics and aggregate HMDA averages.”

Undoubtedly, this approach utilizes nothing more than a quota-based metric, which the Supreme Court in Harvard squarely rejected. Indeed, the Supreme Court reasoned that race-based programs amount to little more than determining how “the breakdown of the [incoming] class compares to the prior year in terms of racial identities,” or comparing the racial makeup of the incoming class to the general population, to see whether some proportional goal or benchmark has been reached.

While the goal of meaningful representation and diversity is commendable, the Supreme Court emphasized that “outright racial balancing and quota systems remain patently unconstitutional.” And such a focus on racial quotas means that lenders could attempt to minimize or even eliminate their fair lending risk simply by decreasing their lending in majority-non-Hispanic-White neighborhoods—without ever increasing their loan applications or originations in majority-minority neighborhoods. Of course, this frustrates the essential purpose of ECOA and other fair lending laws.

Potential Constitutional Scrutiny of Race-Based Lending Efforts

If race-based state action, including the use of racial quotas, violates the Equal Protection Clause, it is possible that the race-based lending measures recently encouraged and even required by federal regulators may be constitutionally problematic. In addition to racially targeted loan subsidies and racially motivated loan officer hiring, regulators continue to encourage lenders to implement special purpose credit programs (SPCPs) to meet the credit needs of specific racial or ethnic groups. As the CFPB noted in its advisory opinion, “[b]y permitting the consideration of a prohibited basis such as race, national origin, or sex in connection with a special purpose credit program, Congress protected a broad array of programs ‘specifically designed to prefer members of economically disadvantaged classes’ and ‘to increase access to the credit market by persons previously foreclosed from it.’”

While SPCPs are explicitly permitted by the language of ECOA and its implementing regulation, Regulation B, as an exception to the statute’s mandate against considering a credit applicant’s protected characteristics, it is uncertain whether these provisions, if challenged, would survive constitutional scrutiny by the current Supreme Court.

Takeaways for Lenders

For the time being, lenders that offer SPCPs based on a protected characteristic should ensure that their written plans continue to meet the requirements of Section 1002.8(a)(3). As always, the justifications for lending decisions that could disproportionately affect consumers based on their race, ethnicity, or other protected characteristic should be well documented and justified by legitimate business needs. And if faced with a fair lending investigation or potential enforcement action, lenders should consider presenting to regulators any alternate data findings or conclusions that demonstrate the institution’s record of lending in MMCTs rather than focusing on the rates or percentages of other lenders in the geographic area.

Oh Snap! CFPB Sues Fintech Company under CFPA and TILA

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A&B Abstract:

On July 19, 2023, the Consumer Financial Protection Bureau (CFPB) sued a Utah-based fintech company and several of its affiliates (the Company) for allegedly deceiving consumers and obscuring the terms of its financing agreements in violation of the Consumer Financial Protection Act (CFPA), the Truth in Lending Act (TILA), and other federal regulations.

The Allegations

The Company provides lease-to-own financing, through which consumers finance purchases from merchants though the Company’s “Purchase Agreements,” and, in turn, make payments back to the Company.  The Company allegedly provides the merchants with advertisement materials and involves them heavily in the application and contracting process.

According to the CFPB, the Company’s advertising and servicing efforts were deceptive.  As part of its marketing efforts, the Company allegedly provided its merchant partners with display advertisements that featured the phrase “100 Day Cash Payoff” without further explanation of the terms of financing.  Consumers who received financing from the Company reasonably believed they had entered into a 100-day financing agreement, where their automatically scheduled payments would fulfill their payment obligations after 100 days.  But, in fact, consumers had to affirmatively exercise the 100-day early payment discount option, and if they missed the deadline pay significantly more than the “cash” price under the terms of their Purchase Agreements.  Additionally, as part of its servicing efforts, the Company allegedly threatened consumers with collection actions that it does not bring.

From the CFPB’s perspective, these efforts constituted deceptive acts or practices under the CFPA.  The marketing efforts were deceptive because the Company’s use of this featured phrase was a (1) representation or practice; (2) material to consumers’ decision to take out financing; and (3) was likely to mislead reasonable consumers as to the nature of the financing agreement, while the servicing efforts were deceptive because the Company threatened actions it does not take.

The CFPB also alleges that the Company’s application and contracting process was abusive.  The Company allegedly designed and implemented a Merchant Portal application and contracting process that frequently resulted in merchants signing and submitting Purchase Agreements on behalf of consumers without the consumer’s prior review of the agreement.  Further, the Company relied on merchants to explain the terms of the agreements but provided them with no written guidance for doing so.  And as part of the process, the Company required consumers to pay a processing fee before receiving a summary of the terms of their agreement and before seeing or signing their final agreement.

Altogether, the CFPB views these acts and practices as abusive under the CFPA because they “materially interfered” with consumers’ ability to understand the terms and conditions of the Purchase Agreements.

Lastly, the CFPB alleges that the Company’s Purchase Agreements did not meet TILA and its implementing Regulation Z’s disclosure requirements.  On this point, the CFPB is careful in alleging that the Purchase Agreements are not typical rent-to-own agreements to which TILA does not apply.  Rather, the CFPB alleges they are actually “credit sales” because the agreements permitted consumers to terminate only at the conclusion of an automatically renewing 60-day term, and only if consumers were current on their payment obligations through the end of that term.

Takeaways

This suit serves as a good reminder to every lending program to: (i) have counsel carefully vet all advertisements to ensure that they are not inadvertently deceptive or misleading to consumers; (ii) ensure that the mechanics of its application process facilitate rather than interfere with consumers’ ability to understand the terms and conditions; and (iii) consult with counsel regarding whether their agreements are subject to TILA and Regulation Z’s disclosure requirements.

Being a Government Agency is not an Exception to the Federal Discovery Rules

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A&B Abstract:

When litigating in federal court, government agencies are not exempt from the rules of discovery.  The Eleventh Circuit reminded the Consumer Financial Protection Bureau (“CFPB”) of this in its recent decision CFPB v. Brown, et al., No. 21-14468 (11th Cir. 2023).  There, the Court affirmed a district court’s sanctions order dismissing the CFPB’s claims against five defendants because the CFPB had “engag[ed] in dramatic abuse of the discovery process.”

The Case

“The CFPB’s problematic conduct began during discovery.”  In response to Rule 30(b)(6) deposition notices from five defendants to depose a CFPB representative, the CFPB objected that: (i) it had already provided the information in its interrogatory responses, (ii) the notice inquired into topics covered by the law enforcement and deliberative process privilege, and (iii) the depositions were an improper attempt to question CFPB counsel about their mental impressions and analyses.  The district court, however, overruled these objections “reasoning that Rule 30(b)(6) applies with equal force to government agencies” and that “factual matters are subject to inquiry even if those matters have been disclosed in interrogatory responses.”

The CFPB then moved for a protective order to reduce the scope of the 30(b)(6) depositions.  The district court granted this in part, striking the balance that “facts—including ‘exculpatory facts’—were fair game while questioning that ‘would delve into [the CFPB’s] trial strategy’ was off limits.”  With this guidance in hand, the parties proceeded with their depositions.

In the first 30(b)(6) deposition, “the CFPB avoided answering questions through a number of impermissible tactics.”  It lodged work product objections even to fact-based questions that the district court had instructed it to answer.  It equipped its witness with “memory aids”—lawyer-prepared scripts that were hundreds of pages in length—from which the witness repeatedly engaged in “filibuster-style reading.”  And despite the district court’s instruction that it should answer questions concerning exculpatory facts, the CFPB took the position that it had not identified any exculpatory facts in the entire voluminous record.

Given the CFPB’s tactics during the first deposition, the defendants requested, and the district court conducted, a telephonic hearing.  During the hearing, the district court provided further instruction warning the CFPB off of these tactics.  The district court also reiterated that “defendants were entitled to question the CFPB about exculpatory facts.”  And that while “exculpatory information” is generally a term used in criminal cases, a defendant in a civil case is entitled to discovery of exculpatory evidence that would be in the possession of a government agency that would show the defendant had not committed the alleged violations.

During the next four 30(b)(6) depositions, “the CFPB continued its obstructionist conduct.”  Specifically, it continued to object on work product grounds, its witness continued to rely exclusively on memory aids for his testimony, and its witness refused even to answer yes or no questions as to whether certain facts existed.

Consequently, defendants moved for sanctions.  The district court granted sanctions, struck all claims against the five defendants, and dismissed them from the case.

In granting this sanction, the district court found that the CFPB had willfully disregarded the district court’s instructions by reading from memory aids to bury defendants in so much information that they could not possibly identify, with any reasonable particularity, what supported the CFPB’s claims.  The district court also found that the CFPB’s witness failed to appear because, even though he was physically present, he was effectively unavailable because he could not answer questions without memory aids and because of his “refusal to address exculpatory evidence.”  Finally, the district court explained that it was not optimistic that reopening the depositions would be fruitful given the CFPB’s pattern of conduct in the case.

On appeal, the Eleventh Circuit explained that the district court’s instructions and orders were clear, so the CFPB’s failure to comply with them warranted sanctions.  It also held that in light of the district court’s conclusion that reopening discovery would not be fruitful, the severe sanction of dismissal was warranted.

Takeaways from the Court’s Ruling

In affirming, the Eleventh Circuit provided an important reminder that government agencies are not exempt from the rules of discovery.  They “do[] not have the power to decide which discovery rules [they] will abide by and which [they] will ignore.”

Throughout its decision, the Eleventh Circuit also highlighted the proper and improper uses of memory aids during 30(b)(6) depositions.  Memory aids can be used (and can be useful) during these types of depositions so long as they do not replace the witness’s testimony.  It is when they stop being memory aids and become lawyer‑prepared scripts that their use becomes improper.  They cannot replace live testimony, and where the 30(b)(6) witness cannot testify without relying upon the memory aids, the witness is effectively unavailable.

Finally, in its decision, the Eleventh Circuit stressed that it was improper for the CFPB “to take the incredible position that exculpatory facts did not exist as to any defendant in the case.”  While the CFPB argued on appeal that it was improper for the district court to order it to specifically identify evidence that it considered exculpatory, the circuit court concluded that the district court had not asked the CFPB to go that far.  Rather, the district court had merely made clear that exculpatory evidence is fair game as part of the discovery process.

In short, parties being sued by a government agency are entitled to discovery, including through 30(b)(6) deposition testimony, about the factual bases for the government agency’s claims against them.  This entitlement extends to exculpatory evidence in possession of the government agency that would show the defendant had not committed the alleged violations.

CFPB Issues Preemption Determination that State Commercial Financing Disclosure Laws Are Not Preempted By TILA

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A&B Abstract:

The Consumer Financial Protection Bureau (CFPB) recently announced that it issued a final preemption determination concluding that certain state disclosure laws applicable to commercial financing transactions in California, New York, Utah, and Virginia are not preempted by the federal Truth in Lending Act (TILA). As covered in a previous post, we note that the California, Utah, and Virginia laws have already gone into effect, and New York’s is set to become effective on August 1, 2023.

State Commercial Lending Laws

After examining the state disclosure laws in California, New York, Utah, and Virginia, the CFPB recently affirmed that there is no conflict with TILA because the state laws extend disclosure protections to businesses seeking commercial financing, which are beyond the scope of TILA’s statutory consumer credit protections.  Specifically, the CFPB determined that TILA only preempts state laws under conflict preemption, which the CFPB interprets to mean that TILA preempts state laws only if they are “inconsistent” with TILA.

In California, New York, and Utah, state laws require lenders to issue disclosures in certain commercial financing transactions, the purpose of which is generally defined to mean primarily for other than personal, family, or household purposes.  This is in contrast to TILA’s application to consumer credit, which is extended primarily for personal, family, or household purposes.  In December 2022, the CFPB made a preliminary determination that New York’s commercial financing disclosure law was not preempted by TILA because the state law regulates commercial financial transactions rather than consumer-purpose transactions.

In Virginia, disclosures are required in connection with “sales-based financing,” which is defined generally as a transaction in which the financing is repaid by the recipient based on a percentage of sales or revenue.  “Recipient” means a person whose principal place of business is in Virginia and that applies for sales-based financing and is made a specific offer of sales-based financing by a sales-based financing provider.  Based on these definitions, it appears that the Virginia law would not apply to a consumer credit transaction.  However, the CFPB generally noted that, to the extent state law could apply to a consumer credit transaction, there would still be no inconsistency with TILA.

Accordingly, the CFPB found that the four states’ commercial financing disclosure laws are not inconsistent with and, therefore, not preempted by the federal TILA.

Takeaway

As states continue to propose and enact similar laws requiring disclosures in commercial financing transactions, an argument that federal law preempts such state laws is unlikely to succeed.  Thus, companies should monitor ongoing state regulatory trends in commercial financing transactions to ensure compliance with the consumer-style disclosure requirements that may apply.

Second Circuit Deepens Circuit Split over CFPB Funding Structure

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A&B ABstract:

On March 23, 2023, the Second Circuit held the Consumer Financial Protection Bureau’s (CFPB) funding structure is constitutional.  This decision comes on the heels of the Supreme Court granting certiorari to review the Fifth Circuit’s ruling in Community Financial that reached the opposite conclusion.

The Second Circuit’s Ruling

The Second Circuit case, styled Consumer Financial Protection Bureau v. Law Offices of Crystal Moroney, looks at a challenge to a civil investigative demand (CID) for documents made to a law firm that principally advises and services clients seeking to collect debts.  On appeal, the law firm argued the CID could not be enforced because, for among other reasons, the funding structure of the CFPB violated the Appropriations Clause of Article I of the Constitution.

Rejecting this argument, the Second Circuit held that the Appropriations Clause provides “simply that no money can be paid out of the Treasury unless it has been appropriated by an act of Congress.”  That is, if a payment of money from the Treasury is “authorized by statute,” then it does not run afoul of the Appropriations Clause.  And “[t]here can be no dispute that the CFPB’s funding structure was authorized by the CFPBA – a statute passed by Congress and signed into law by the President.”

In reaching this conclusion, the Second Circuit declined to follow the Fifth Circuit’s rationale in Community Financial.  There, the Fifth Circuit reasoned that the CFPB’s funding structure violated the separation of powers embodied in the Appropriations Clause because it was “doubly” insulated from Congressional control.  Specifically, the Fifth Circuit posited that Congress had first ceded control directly over the CFPB’s budget by insulating it from review during the annual appropriations process and second conceded control indirectly by providing that the CFPB’s funding be drawn from a source that was itself outside the appropriations process.

In response to this, the Second Circuit explained that, in its view, the design of the Constitution in the Appropriations Clause was to ensure that the purpose, limit, and fund of every expenditure be ascertained by a previous law.  Thus, as long as the CFPB’s budget had an articulated purpose (as set forth in the CFPA), came from an articulated fund (the earnings of the Federal Reserve System), and had articulable limits (a 12% cap set by Congress in the CFPA), then it was constitutional.  In short, Congress specified the purpose, limit, and fund of its appropriation for the CFPB’s budget in the CFPA, which was all that the Constitution required.

Takeaway

Whether the CFPB’s funding structure is constitutional poses a possibly existential threat to the CFPB’s operations.  The Second Circuit’s decision deepens the split on the issue, which the Supreme Court has already begun undertaking to resolve.  Stay tuned for further updates on how the Supreme Court resolves this split.