Auto Financing Industry Facing Increased Regulatory Scrutiny for Discriminatory Lending Allegations
Several recent Department of Justice settlements have highlighted a potential risk for auto lenders. Beyond eliminating intentionally discriminatory practices like redlining, auto lenders need to work with legal counsel, lending officers, lending algorithm programmers and other stakeholders to ensure lending practices do not result in unintentional discrimination.
Over the previous two years, the U.S. Department of Justice has announced six settlements to address modern day redlining practices (race-based discrimination), totaling $84 million in penalties.1 Although the DOJ’s “Combating Redlining Initiative” has focused on mortgages thus far, this initiative has the potential to reach the auto lending market as well, which has seen its own share of enforcement actions related to discriminatory lending in recent years.
In bringing discriminatory lending charges, the DOJ generally relies on the Fair Housing Act (FHA) and the Equal Credit Opportunity Act (ECOA). Although the FHA only covers housing transactions, the ECOA proscribes discrimination by “any creditor.”2 Because auto loans made up $1.55 trillion of the consumer lending market
as of Q4/22, these transactions are ripe for DOJ scrutiny.3
RAMPANT DISCRIMINATION IN AUTO LENDING REMAINS A CONCERN FOR REGULATORS
Vehicle ownership plays a vital role in daily American life. For instance, 92% of commuters rely on cars to travel to work4 and many others require them to obtain essentials such as food and medical care. Car ownership is generally dependent on financing availability and usually represents a significant monthly expense. As of Q4/22, 80.85% of new cars are financed, with an average monthly payment of $716, while 39.81% of used cars are financed, with an average monthly payment of $526.5
Accessing auto loan financing can be difficult for Black, Latino and Hispanic auto loan applicants.6 Even when auto loan applicants of color access financing, it is often at higher interest rates, regardless of creditworthiness. On average, applicants of color receive loans with interest rates 0.7% higher than comparative white borrowers, even though borrowers of color default less frequently.7 This extra markup for borrowers of color results in an additional $1,400 of interest over the life of a typical auto loan.8 These data points were presented to the Consumer Financial Protection Bureau during its 2021 research conference.9 The CFPB is already closely examining the auto lending market. In late February, the CFPB announced it is conducting an extensive inquiry into auto lending portfolios, including requesting information from nine large auto lenders.10 These requests are in response to the regulator’s aim to create greater transparency in the market. Following its analysis, the CFPB expects to monitor risks to consumers and publish the results. These insights have the potential to impact the CFPB’s investigations into discrimination in the auto lending market.
The CFPB and DOJ have already shown an appetite for bringing enforcement actions against auto lenders who discriminate against applicants of color. In 2013, for example, the CFPB and DOJ ordered an auto finance lender to pay $98 million for allegedly charging 235,000 such borrowers higher interest rates over the course of a nearly three-year period.11 At that time, it was the largest auto loan discrimination settlement with the federal government in U.S. history.
Of note, auto finance lenders can be held liable for the upstream lending activities of car dealerships arranging loans on their behalf. Under the ECOA, auto finance lenders are liable for discrimination if the finance company permits dealer markups, if it compensates dealers on that basis and if a protected class is charged a higher interest rate than otherwise comparative borrowers.12
State regulators are also investigating and penalizing fair lending violations concerning auto loans. In late 2022, the New York Department of Financial Services announced a settlement with an auto lender that, similar to the preceding example, allegedly charged borrowers of color higher interest rates.13
Relatedly, car dealerships have also recently been investigated under the ECOA for racial discrimination in auto loans. The DOJ, CFPB and Federal Trade Commission (FTC) are jointly targeting this type of discriminatory lending, achieving settlements with a Maryland dealership in 202014 and a multi-state dealership group in 2022.15 Each settlement related to allegations that the dealerships offered different terms of credit based on the race of prospective borrowers.
ILLEGAL REDLINING CAN INCLUDE UNINTENTIONAL CONDUCT
There is an opportunity for lenders and car dealerships to work with legal counsel and key stakeholders to prevent potential discrimination. Indeed, proactive measures may assuage concerns from regulatory agencies and prevent enforcement actions and the very discrimination that would necessitate them in the first place.
In addition to intentional discrimination, the ECOA also holds parties liable for disparate treatment on the basis of race, color, religion, national origin, sex, marital status, or age, regardless of intent to discriminate.16 The potential reach of the statute is considerably broad and can implicate automated systems that produce lending decisions with a disparate impact on protected classes. This is especially noteworthy given lenders’ increasing reliance on automated processes. Rohit Chopra, the director of the CFPB, has noted that one of the federal government’s priorities involves eliminating the use of discriminatory algorithms.17
Unlike overt redlining, algorithms can create a black box-like system that prevents all but the most informed and sophisticated programmers and data scientists from understanding exactly how the algorithms reach their decisions and whether those decisions are unintentionally reliant on race or national origin-related data.
One of the companies using machine learning to reimagine the auto loan industry is Zest AI, which used algorithms to increase loan approvals by 14% at one of its clients.18 But Jay Budzik, Zest’s chief technology officer, has openly acknowledged the risk of these tools inadvertently discriminating on the basis of race using seemingly innocuous data points, such as where an applicant lives.19
There is a wide range of data used in algorithms to gauge creditworthiness and assign an interest rate, including social media use, internet browsing, geolocation data and other smartphone information.20 Unfortunately, this data can be unintentionally used to disparately impact protected classes. It is imperative that lenders who rely on algorithms in their lending decisions have strong compliance programs in place to avoid inadvertent discrimination and regulatory actions.
With these recent settlements and risks in mind, the CFPB has proposed specific steps lenders can take to avoid violating the ECOA, including developing a robust fair lending compliance management program and imposing controls on dealer markup and compensation policies or otherwise revising and monitoring the effects of those policies to address unexplained pricing disparities on a prohibited basis.21 Alternatively, lenders may eliminate markups as a potential source of discrimination by removing dealer discretion to mark up loan interest rates altogether and fairly compensating dealers using another mechanism, such as a flat fee per transaction.22 CFPB Bulletin 2013-02 has further recommendations for companies to consider when establishing effective compliance processes. By investing in robust compliance on the front-end, auto lenders can avoid regulatory enforcement actions and the costs stemming from those actions.
In addition to potential government enforcement actions, publicly-traded auto lenders should be mindful that they could be opening themselves up to shareholder proposals that may request a racial equity or civil rights audit to understand how their lending practices impact people of color. A growing number of shareholders have requested that companies perform such audits to examine the impact of their policies, procedures and practices on people of color, particularly when information has come to light suggesting that people of color have been harmed in some way by a company’s practices. In fact, calls for racial equity and civil rights audits gained significant momentum in the 2022 proxy season, with shareholders filing 43 proposals within the Russell 3000.23 Eight of those proposals received majority support in the most recent year compared to none in 2021.24 Despite the increased number of shareholder proposals, implementing the compliance measures discussed in this article may reduce the need for such an audit.
Ultimately, auto lenders will need to work with legal counsel, lending officers, lending algorithm programmers and other stakeholders to ensure that their lending practices do not result in unintentional discrimination against protected classes.
1Press Release, Dept. of Just., “Justice Department Secures $9 Million from Park National Bank to Address Lending Discrimination Allegations,” Feb. 28, 2023.
242 U.S.C. §§ 3604–06; 15 U.S.C. § 1691(a).
3“Household Debt and Credit Report (Q4 2022),” Federal Reserve Bank of New York, Feb. 2023.
4Lanning, J. “Evidence of Racial Discrimination in the $1.4 Trillion Auto Loan Market,” ProtfitWise, Jan. 2023.
5Experian, “State of The Automotive Finance Market Q4 2022,” 2023.
6Butler A., et al., “Racial Discrimination in the Auto Loan Market,” Consumer Financial Protection Bureau, March, 31, 2021.
7Id. at 26–27, 32–34.
8J. Lanning, “Evidence of Racial Discrimination in the $1.4 Trillion Auto Loan Market,” ProtfitWise, Jan. 2023.
9Lapid, P, et al. “Summary of the 2021 CFPB Research Conference,” Consumer Financial Protection Bureau, May 27, 2021.
10Kukla, C, et al. “Our Auto Finance Data Pilot,” Consumer Financial Protection Bureau, Feb. 23 2023.
11Press Release, Consumer Financial Protection Bureau, “CFBP and DOJ Order Ally to Pay $80 Million to Consumers Harmed by Discriminatory Auto Loan Pricing,” Dec. 30, 2013.
12Consumer Financial Protection Bureau, Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act, Mar. 31, 2013. Although a joint resolution was passed by Congress disapproving this bulletin, the ECOA and its implementing regulation, Regulation B, are unchanged and remain in force and effect.
13Press Release, New York Department of Financial Services, “DFS Superintendent Adrienne A. Harris Announces Settlement with Rhinebeck Bank to Resolve Fair Lending Violations Concerning Auto Loans,” Oct. 6, 2022.
14Press Release, DOJ, “Department Settles Lending Discrimination Lawsuit with Maryland Used Car Dealership,” July 2, 2020.
15Gressin, S, “Auto Dealers to Pay $10 Million for Discriminatory Lending and Sneaking in Junk Add-on Fees,” Federal Trade Commission, Apr. 1, 2022.
1612 C.F.R. § 1002.1(b) (2017); 12 C.F.R. § 1002.4(a)1 (Supp.) (2017).
17Press Release, DOJ, “Justice Department Announces New Initiative to Combat Redlining,” Oct. 22, 2021.
18Azulay, D, “AI for Auto Lending – Improving Deal Flow and Risk Reduction with Data,” Emerj, Jan. 27, 2020.
20Faggella, D, “Artificial Intelligence Applications for Lending and Loan Management,” Emerj, Apr. 3 2020.
21“Indirect Auto Lending and Compliance with the Equal Credit Opportunity Act,” Consumer Financial Protection Bureau, Mar. 31, 2013.
23Press Release, “In the 2022 Proxy Season, Proposals on Climate Disclosures and Racial Equity Audits Gained Significant Momentum,” PR Newswire, Sept. 28, 2022.
ABOUT THE AUTHORS: Johnjerica Hodge and India D. Williams are co-chairs of Katten’s ESG risk and investigations practice, which draws on their background in compliance and criminal and internal investigations to help clients address ESG policy concerns, mitigate ESG-related risks and take any needed remedial steps. Nicholas Bottcher is a former litigation associate at Katten.