The CFPB’s recent consent order with Ally Bank reminds me of the Hans Christen Anderson children story “The Emperor’s New Clothes”.

In that story, a vain emperor who wants to be the best-dressed person in the world hires a pair of tailors to outfit him. Upon presentation of his new clothing, the tailors tell the emperor they have dressed him with a fabric invisible to anyone who is unfit for his position or “hopelessly stupid”. The Emperor’s ministers cannot see the clothing themselves, but pretend that they can for fear of appearing unfit for their positions and the Emperor does the same. The Emperor marches in a procession before his subjects. The townsfolk play along with the pretense, not wanting to appear unfit for their positions or stupid. Then a child in the crowd, too young to understand the desirability of keeping up the pretense, blurts out that the Emperor is wearing nothing at all and the cry is taken up by others. At that point, the game is over.

The CFPB reminds me of the Emperor. They must know that the legal arguments they hope to validate in the Ally Bank Consent Order will not hold up in a court. My fear is that other lenders will be like the Emperor’s ministers and go along for fear that they will be the next entity upon which the CFPB will try to impose similar conditions and thus they go along as well.

Ally Bank is an indirect financier of retail installment sales contracts originated by auto dealers, an “indirect lender” if you will. The CFPB used a questionable “proxy” method to try to identify who among Ally’s accounts were in an Equal Credit Opportunity Act (“ECOA”) protected class of persons (sex, marital status, race, color, religion, national origin, age, or the fact that all or part of the applicant’s income derived from public assistance programs). The proxy method it used, the Bayesian Improved Surname Geocoding (“BISG”) method has been criticized as overstating African-Americans and Hispanics and understating Caucasians. But no matter. The CFPB determined that since April 2011, 235,000 African-American, Hispanic, and Asian/Pacific Islander borrowers were marked up between 20 and 29 basis points more than white persons and these differences are statistically significant. The CFPB dismissed summarily that any of these differences reflected a legitimate business objective. Not one of the 235,000 accounts. They penalized Ally to the tune of $98 million, $80 million in reimbursements to the 235,000 accounts and $18 million as a civil penalty to the CFPB.

Like the Emperor, the CFPB has to know that its statistical and legal analyses that were effectively forced onto Ally are questionable at best. In the last two Supreme Court terms, cases that challenged the validity of a “disparate impact” claim under the Fair Housing Act (which has identical language as ECOA) were settled by the Department of Justice before the Supreme Court had to opportunity to hear arguments. Why do you suppose that happened? No federal appellate court has ever upheld “disparate impact” as a legitimate cause of action under ECOA and the D.C. Circuit questioned its validity.

ECOA’s Regulation B is very clear on when a subsequent creditor is liable for the discriminatory acts of a prior creditor (this assumes the dealer, the prior creditor, somehow violated ECOA). Lender liability in indirect auto finance requires one of two circumstances: Either the lender participated in the credit decision including setting the terms of credit or “the person knew or had reasonable notice of the act, policy, or practice that constituted the violation before becoming involved in the credit transaction.”

The CFPB knows that it is the dealer who sets the terms of credit, especially in a spot delivery situation where the lender does not even see the customer’s credit application until after the contract is signed. Nor would a lender know of a “disparate impact” violation before becoming involved in the credit transaction because disparate impact requires a statistical analysis well after-the-fact and consideration of whether legitimate and non-discriminatory business reasons justified a pricing differential in each case. As the Department of Justice’s (“DOJ”) representative stated at the CFPB’s Auto Finance Hearing in November 2013, “ECOA neither requires nor prohibits discretionary pricing.”

NADA’s Fair Credit Compliance Policy and Program, released on January 24, 2014, represents an excellent approach to compliance that the DOJ first used in two cases settled in 2007 (Pacifico and Springfield Ford) and then repeated as a means to comply in its testimony at the CFPB hearing in November 2013.

Briefly summarized, here’s how it works: You charge finance customers on a uniform basis over the wholesale buy rate. This can be a fixed number of basis points over the buy rate, a fixed percentage of the amount financed, or a fixed dollar amount. The two 2007 cases both involved establishing a uniform dealer participation rate that is applied to all customers unless one of seven legitimate business reasons apply in which case the standard rate could be reduced, but never increased. The seven legitimate business reasons are as follows:

• Dealer participation is limited by the lender;
• The customer stated a monthly payment constraint of $____ per month;
• The customer stated a competing offer by another finance source of ___%;
• The customer qualified for a Dealership Promotional Financing Campaign;
• The customer qualified for a subvened interest rate of ___% from the lender;
• The customer qualified for the Dealership Employee Incentive Program; and
• The customer purchased a vehicle that satisfied the dealership’s predetermined inventory reduction criteria along with an explanation of how the vehicle satisfied the established criteria

A dealership should have the ability to add additional nondiscriminatory legitimate business reasons provided they are limited to neutral, pro-competitive factors that are completely unrelated to the customer’s status as a member of a protected class and are executed in good faith. These reasons would have to be specifically identified in advance as an open-ended category of “Other” could provide the basis for a lender or regulator to claim the dealer was discriminating on the fly.

By adopting such a program, documenting for each deal any variations by indicating the applicable reason and including supporting documentation (such as a customer’s commitment from a competing finance source at a lower rate), the dealer is best positioned to defend a disparate impact claim. If you have not read the NADA policy, I encourage you to do so as it provides a conservative framework to set yourself up in the event a lender or regulator wants to audit your compliance.

Until the young boy states that the Emperor has no clothes, likely coming from a lender defending an enforcement action in a federal court (at which point I suspect the rules of the game will change radically), you will continue to be periodically audited by some of your lenders. The NADA Policy or another program designed in a similar manner is how you can best respond. To date, we have not seen lenders push for flats on a widespread basis which is the CFPB’s ultimate goal.