Department of Justice and Evergreen Bank Group Enter into Consent Order Requiring Implementation of Dealer Compensation Policy and Payment of $395,000 in Consumer Redress SUMMARY On May 7, 2015, the Department of Justice (“DOJ”) announced that it had reached a settlement with Evergreen Bank Group of Oak Brook, Illinois (“Evergreen Bank” or the “Bank”) to resolve allegations of discriminatory lending practices relating to indirect motorcycle lending. The consent order (the “Consent Order”) requires Evergreen Bank to pay $395,000 in consumer redress and to implement dealer compensation policies to remedy alleged violations of the Equal Credit Opportunity Act (“ECOA”).1 The Evergreen Bank Consent Order is the first public enforcement action since the December 2013 coordinated orders against Ally Financial and Ally Bank (“Ally”) by DOJ and the Consumer Financial Protection Bureau (the “CFPB” or the “Bureau”) based on a theory that a lender’s policies permitting discretionary dealer pricing may result in a discriminatory “disparate impact” on protected groups.2 BACKGROUND ECOA. Under ECOA, it is unlawful for any creditor to discriminate against any applicant on the basis of race, color, religion, national origin, sex or marital status, or age. The agencies interpreting ECOA and its implementing Regulation B (the Federal Reserve and now the CFPB) have taken the view that the statute prohibits both “disparate treatment” and “disparate impact.”3 Although DOJ does not have rulemaking or interpretive authority, it has the authority to enforce ECOA against any creditor. -2- Department of Justice Announces Settlement to Resolve Discriminatory Indirect Lending Allegations May 12, 2015 In the indirect lending context, DOJ and the CFPB have taken the view that the ultimate financing source for vehicles has an obligation not to allow the selling dealers to use discretion to charge members of protected groups a higher “dealer mark-up” (sometimes called “dealer participation” or “dealer reserve”) on top of the “buy rate” (the rate at which the lender is willing to extend credit to the consumer) than is charged to members of non-protected groups. The CFPB’s March 2013 Guidance. In March 2013, the CFPB issued guidance (the “March 2013 Guidance”) regarding compliance with ECOA and Regulation B in the context of indirect auto lending. Because the CFPB does not enjoy authority over dealers, its guidance focused on potential risks to indirect lenders arising from their dealer compensation policies and described certain policies and practices that would reduce an indirect lender’s fair lending risk and likelihood of being cited for an ECOA violation. Specifically, the March 2013 Guidance suggests that indirect auto lenders either should (1) impose controls on dealers’ discretionary mark-ups, including systems for monitoring dealers and taking corrective action, or (2) eliminate dealer discretion entirely. The March 2013 Guidance further indicated that an indirect auto lender that permits dealers to mark up the buy rate may be liable under the theories of disparate treatment and disparate impact. An indirect auto lender may incur liability when its compensation policies result in pricing disparities on a prohibited basis (i.e., higher mark-ups for protected groups). Notably, the March 2013 Guidance states that “[t]he disparities triggering liability could arise either within a particular dealer’s transactions or across different dealers within the lender’s portfolio.” A portfolio-wide statistical analysis could show disparities even in the absence of any individual dealer actually charging its own protected group customers more than its non-protected group customers. The March 2013 Guidance was widely interpreted as “pressuring lenders to eliminate or severely limit an auto dealer’s discretion to negotiate competitive financing for customers.”4 The Ally Settlement. On December 20, 2013, DOJ and the CFPB announced a settlement with Ally requiring the payment of $80 million in consumer redress and $18 million to the CFPB’s Civil Penalty Fund. Ally was given two options for its dealer compensation policies going forward. First, Ally could implement a “Compliance Plan” which included a quarterly analysis of dealer-specific pricing data, and a quarterly and annual analysis of portfolio-wide pricing data, for identifying disparities on a prohibited basis resulting from Ally’s dealer compensation policy. Upon identifying disparities that exceed an undisclosed threshold, Ally would be required to implement corrective action and remuneration of affected consumers, as applicable. As an alternative, Ally could implement, subject to DOJ and CFPB review, a “Non-Discretionary Dealer Compensation Plan,” which would comprise a non-discretionary dealer compensation structure along with an appropriate compliance management system. The Summer 2014 Supervisory Highlights. Since the Ally settlement, the CFPB has discussed its indirect auto-lending initiative in its Supervisory Highlights publication (the “Summer 2014 Guidance”).5 Beyond the March 2013 Guidance that effectively proposed two options for reducing fair lending risk (a -3- Department of Justice Announces Settlement to Resolve Discriminatory Indirect Lending Allegations May 12, 2015 compliance program with statistical monitoring, or elimination of dealer discretionary pricing), the Summer 2014 Guidance set forth a third possible method of mitigating fair lending risk: reducing the “caps” imposed by the lender on dealer discretion (the maximum mark-up) from 200 to 250 basis points depending on the duration of the loans to 100 basis points “for example.” The Statistical Methodology Issue. Creditors are prohibited under Regulation B from asking applicants their race or national origin.6 Because of this “missing data,” the government agencies rely on a “proxy methodology” for determining the protected group status of individual applicants. The CFPB and DOJ have relied on a method called Bayesian Improved Surname Geocoding (“BISG”), derived from a combination of Census Bureau surname and geography data, to estimate the probabilities that an individual is a member of a particular group. In September 2014, the CFPB issued a white paper explaining the use of the BISG method, and contending that it produces reasonably accurate results.7 In contrast, the economic consulting firm Charles River Associates released a report prepared on behalf of the American Financial Services Association, a trade group, which found that the BISG method produces “objectively high error rates.”8 Use of the BISG method remains controversial, although Charles River Associates acknowledged that it produced somewhat better results than relying on geography or surnames alone. ALLEGATIONS AGAINST EVERGREEN BANK Evergreen Bank, a state-chartered non-member bank headquartered in Oak Brook, Illinois with approximately $500 million in assets (and, therefore, not subject to CFPB jurisdiction), has in recent years annually originated between 6,000 and 12,000 motorcycle loans through a network of roughly 400 motorcycle dealers located in all 50 states. In March 2013, the Federal Deposit Insurance Corporation (“FDIC”), the Bank’s primary federal regulator, referred the Bank to DOJ alleging a pattern or practice of lending discrimination.9 DOJ’s complaint, dated May 7, 2015 (the “Complaint”) alleges that Evergreen Bank had caused discrimination against Hispanic and African-American borrowers who obtained loans from the Bank to finance the purchase of motorcycles by allowing dealers to include mark-ups in interest rates not based on objective criteria related to borrower risk. The Complaint largely mirrors in language and structure the complaint filed by DOJ to support the Ally Order in December 2013. According to the Complaint, the Bank allowed motorcycle dealers to apply a mark-up (capped at 300 basis points for most non-promotional loans) to the interest rate that the Bank had set based on the creditworthiness of each borrower. The Complaint alleges that the Bank created incentives for dealers to mark up the interest rates charged to borrowers while failing to implement adequate constraints or monitoring to prevent discrimination from occurring. -4- Department of Justice Announces Settlement to Resolve Discriminatory Indirect Lending Allegations May 12, 2015 Based on its statistical analyses, including application of the BISG method, described above, DOJ alleged that: (1) approximately 1,500 Hispanic borrowers were issued motorcycle loans that had dealer mark-ups of 40 basis points higher than non-Hispanic white borrowers and (2) approximately 700 African-American borrowers were issued motorcycle loans that had dealer mark-ups of approximately 29 basis points higher than non-Hispanic white borrowers.10 Both of these disparity levels were measured on a portfoliowide basis, and not dealer-by-dealer. According to the Complaint, the disparities disappeared when the Bank instituted a non-discretionary dealer compensation plan (which compensated dealers based on a fixed percentage of the principal on each loan, as discussed below in more detail) on March 10, 2014. TERMS OF THE CONSENT ORDER The Consent Order requires that the Bank pay $395,000 in remuneration to consumers through a “Settlement Fund” which will be administered by an “Independent Settlement Administrator,” similar to the process used in the Ally matter. In addition, the Bank is required to implement a dealer compensation policy conforming with specified options: The first option is a hybrid, with a combination of limited dealer pricing discretion and a nondiscretionary payment (such as a “flat” dollar amount or percentage of the loan amount). Under this option, dealer discretion in setting the contract rate for any customer would be limited to 130 basis points, 115 basis points or 100 basis points, depending on the term of the loan (the “Standard Participation Rate”). The Bank could also vary the nondiscretionary amount paid dealer-by-dealer and allow dealers to set a lower Standard Participation Rate for particular loan types and/or channels. The Bank may also allow further downward departures under a documented exceptions process. Under this first option, the Bank would have to monitor dealer compliance with the Standard Dealer Participation Rate policy discussed above. Importantly, the Bank would not need to perform periodic statistical monitoring as part of its compliance management program on a dealer-specific or portfolio-wide basis. Under the second option, the Bank would not allow dealers any discretion to modify the rate set by the Bank, its practice since April 2014. The Bank is permitted to have some dealer relationships conform to the first option of “limited discretion” and other dealer relationships subject to the “non-discretionary” second option, but only one of the two compensation systems may be applied to loans purchased from a particular dealer. The third option would allow the Bank to resume the discretionary dealer compensation program that it was using on March 9, 2014, the day before the Bank implemented its nondiscretionary compensation system. Under this option, the Bank must implement and maintain a robust compliance management system, and it would have to perform statistical analyses for each dealer and for the portfolio as a whole. The Bank would also have to take corrective action against dealers with high disparity levels, and remunerate their affected consumers. Similarly, the Bank would have to remunerate consumers if the disparities exceeded an undisclosed threshold amount. -5- Department of Justice Announces Settlement to Resolve Discriminatory Indirect Lending Allegations May 12, 2015 IMPLICATIONS The Evergreen Bank Consent Order may have important implications for a broader resolution of the “disparate impact” dealer compensation issues in the much larger auto financing market. Although the CFPB’s and DOJ’s views on remedies have been evolving since the March 2013 Guidance, the options available to Evergreen Bank allow it considerably more flexibility in constructing a dealer compensation system than has been publicly aired before by either of the agencies. Importantly, the “first option” described above would obviate the need for the Bank to perform an ongoing portfolio-level analysis of pricing disparities using the controversial BISG methodology.11 At least in theory (although perhaps not in practice given the recordkeeping and audit requirements), it would permit dealers to price financing with a range of discretion in the ordinary case, and with more latitude if there is a documented basis for an exception or for a category of products or customers. By permitting the lender to provide a “flat” fee in addition to the lowered discretionary ranges of 130 to 100 basis points, it may result in dealers recouping an equivalent compensation amount compared to the current system, while still permitting considerable negotiation with consumers. Whether this first option structure will prove sufficiently workable for lenders to adopt it, without losing business from dealers in favor of other lenders who continue to permit broader and simpler discretionary pricing by dealers, remains to be seen. It is also not apparent whether the CFPB or DOJ will utilize the first option in future enforcement cases or will seek to make it generally applicable to the industry through guidance, rulemaking or otherwise. The second option (a non-discretionary compensation policy) and the third option (the implementation of monitoring, corrective action and remuneration systems) are broadly similar to the options which were afforded to Ally in December 2013. Inclusion of the third option is significant. Although not characterized as such, use of this option gives Evergreen Bank a “safe harbor” from charges of a violation of ECOA, if it reinstitutes a discretionary dealer compensation model and other compliance efforts fall short of reducing disparities below an undisclosed threshold, although there is a continuing statistical monitoring and remediation requirement. The timing of the Evergreen Bank Consent Order is also of interest, given that the Supreme Court is currently considering whether to validate or reject the disparate impact theory in the context of the Fair Housing Act.12 Although ECOA is not directly at issue in that case, the Court’s opinion, expected by the end of this term in June, is likely to inform how disparate impact claims may be approached under ECOA. DOJ, by issuing this consent order so soon before that opinion is issued, appears to be reaffirming its position that disparate impact enforcement remains vital. -6- Department of Justice Announces Settlement to Resolve Discriminatory Indirect Lending Allegations May 12, 2015 Moreover, the Evergreen Bank Consent Order indicates that DOJ is willing to proceed notwithstanding the criticism voiced that the BISG statistical methodology is unreliable, as set forth in the Charles River report. The Consent Order between DOJ and Evergreen Bank also shows that the regulators are also concerned with niche lending markets, like recreational vehicles and boats, as well as motorcycles, not just automobile lending.