A major legal transition is underway in the world of auto finance. As national regulators step back and federal law retreats, state regulators are stepping up. Changing market conditions are laying kindling for the regulatory and litigation fires to come. As a result, the auto finance industry may soon face serious legal threats from varied state regulators, particularly state attorneys general (AG individually or AGs collectively), many of whom appear poised to act.
These trends hearken back to the mortgage loan calamity triggered by bad credit and securitized loans. When millions of mortgages failed in 2008–2011, state regulators jumped to the fore, resulting in epic regulation and litigation. Although the conditions in the auto finance market appear considerably less severe than those that drove the mortgage meltdown, the latter’s history contains valuable lessons. Among the most important is one frequently forgotten: to beware of complacency founded on Washingtonian sound bites. As it has already done in other spheres, the federal government may indeed scale back its regulatory concern for the auto finance field. However, so long as state AGs stand ready to scrutinize or sue, every business’s net regulatory risk remains substantial. In, many AGs are already closely watching auto finance, sharpening their knives. To counter this looming threat, attorneys advising auto finance lawyers should help their clients embrace basic but proven methods to mitigate or even avoid regulatory attention if—or rather when—another financial bubble bursts.
I. The Current Landscape
A. The Feds Retreat
Federal regulators and federal law are in retreat, as the recent travails of the Consumer Financial Protection Bureau (CFPB or Bureau) show.
On November 1, 2017, a resolution passed by Congress and signed by President Donald J. Trump officially revoked the CFPB’s arbitration rule. Proposed in July 2017, this rule would have banned class-action waivers in arbitration provisions for covered entities. Less than six months later, this prized initiative of the CFPB’s first director, Richard Cordray (Cordray), has been quashed by Washington’s new leadership.
A second setback came soon on its heels. On March 21, 2013, the Bureau issued Bulletin 2013-02, a nonbinding document that targeted dealer markups using “disparate impact” discrimination theories. Deemed advisory, the bulletin had nonetheless become a sore subject in the auto lending industry; many indirect lenders denounced as unfair the CFPB’s determination to penalize them for unintentional purported discrimination by auto dealers, while many questioned the methodology for determining disparate impact. In March 2017, Senator Pat Toomey (R-PA) asked the Government Accountability Office (GAO), Congress’s investigative wing, to determine whether the financial guidance issued in Bulletin 2013-02 qualified as a “rule.” On December 6, 2017, the GAO issued its findings in which it determined that the bulletin qualified as a rule subject to congressional review. This finding nullified the bulletin pending its submission to Congress.
Even before the GAO’s ruling, however, the CFPB appeared to be taking a step back from further dealing with indirect auto lending. At the end of 2016, the Bureau listed its fair-lending priorities, including redlining, mortgage and student loan servicing, and small-business lending, but said nothing regarding the automobile industry. The CFPB in another statement indicated that it would rely less on enforcement in pursuing its fair-lending goals. To many, this omission signaled the CFPB’s desire to reduce its attention to the auto finance industry.
The CFPB’s aggressive tactics endured perhaps its most dramatic setback when Director Cordray announced his early departure on November 15, 2017, and President Trump named Mick Mulvaney, director of the Office of Management and Budget, as the CFPB’s interim director. This appointment has not come without controversy, given that the Senate Democrats contend that the proper head of the Bureau is Leandra English, the deputy director appointed by Cordray. In recent weeks, a federal judge denied English’s request for a temporary restraining order preventing Mulvaney from taking the helm of the Bureau. The uncertainty surrounding the Bureau’s leadership could paralyze much of its operations.
A further sign that the Bureau may scale back its enforcement actions came near the end of the year when it announced that it was withdrawing its request to conduct a survey of individuals related to debt collection disclosures. Although the CFPB has long promised a new rule addressing debt collection, this move calls into question whether its new director wants to deprioritize the rule or even scrap rulemaking altogether.
As the CFPB’s regulatory reach has waned, so has that of the Federal Communications Commission (FCC). The auto finance industry has awaited over a year the result in ACA International v. Federal Communications Commission, currently pending before the United States Court of Appeals for the D.C. Circuit. The case centers on the FCC’s aggressive interpretation of the Telephone Consumer Protection Act (TCPA), a major thorn in the side of auto finance. The D.C. Circuit may strike down the FCC’s previous construction of the TCPA, one made by regulators appointed by President Obama. Regardless, under President Trump, commissioners with a deregulatory bent now control the FCC, as evidenced by the recent reversal of the net neutrality rule by the current majority. Considering this agency’s exclusive authority to issue rules under, and make definitive interpretations of, the TCPA, the FCC will likely take a step back in the years to come.
Although not all federal regulators have been quiet, as seen by the Federal Trade Commission’s recent settlements with auto dealers, federal deregulation is the unmistakable rule of the day.
B. State Regulators’ Forward Momentum
1. New Plans and Old Patterns
State officials have essentially announced their intent to actively patrol the regulatory gaps created by the federal government’s pullback. Soon after President Trump’s election, Maria T. Vullo, superintendent of the New York State Department of Financial Services, reaffirmed her agency’s intent to oversee banks and other financial institutions. New Mexico’s AG, Hector H. Balderas, Jr., just as loudly directed his aides to identify areas where new federal policies enacted could harm New Mexico. Even where silence has reigned, much has been intimated. A former AG of Maryland has already referred to the “enhanced role in protecting consumers moving forward” likely to be assumed by state AGs. Chris Jankowski, a Republican strategist, agreed with this assessment and observed to the New York Times: “State attorneys general are now more permanent pieces on the chessboard of national policy development and implementation. And they are not mere pawns.” Even more AGs have privately revealed plans to redouble their efforts within the consumer protection arena, including the auto finance field.
Another sign of this increasing activity came on December 12, 2017, when a group of 17 state AGs issued a strongly worded letter to President Trump, promising “unwavering support for the mission of the Consumer Financial Protection Bureau” and efforts “to vigorously enforce consumer protection laws regardless of changes to the Bureau’s leadership or agenda.” Expressing concerns regarding President Trump’s appointment of Director Mick Mulvaney, the AGs noted that they “retain broad authority to investigate and prosecute those individuals or companies that deceive, scam, or otherwise harm consumers. If incoming CFPB leadership prevents the agency’s professional staff from aggressively pursuing consumer abuse and financial misconduct, we will redouble our efforts at the state level to root out such misconduct and hold those responsible to account.” Led by New York’s AG Eric Schneiderman, the coalition includes AGs from California, Connecticut, District of Columbia, Hawaii, Illinois, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Mexico, North Carolina, Oregon, Vermont, Virginia, and Washington.
The December 12th letter promises a new wave of state enforcement of consumer regulations following the election of President Trump. These states are taking advantage of a little-known provision of the 2010 Dodd-Frank law, which created the CFPB and gives state AGs the authority to enforce the agency’s rules and its broad ban on “unfair, deceptive and abusive” practices beyond state lines. For example, Pennsylvania’s AG Jack Shapiro has been quickly building up his own consumer finance unit since taking office in January. The Pennsylvania unit is staffed with more than a dozen attorneys and led by a former senior CFPB attorney. “We’re demonstrating a capacity to handle these big, complex, consumer financial protection cases,” Shapiro told Reuters, adding that AGs from both parties have asked how they can “mimic our efforts.”
In Washington, AG Bob Ferguson has similarly enlarged his consumer finance division to 27 attorneys, compared to 11 attorneys in place four years ago. Similarly, California’s AG Xavier Becerra has promised to “carry the torch and build on [former CFPB] Director Cordray’s good work to protect and empower consumers.” “Regardless of what President Trump and the CFPB do moving forward,” said Virginia AG Mark R. Herring, “my fellow attorneys general and I remain committed to fighting to protect consumers across the country, and we will not waver from that commitment.” Herring, like many of his counterparts across the country, has also reorganized and expanded his state consumer protection organization since the election of President Trump.
In addition, there have been open discussions in state AG meetings about the need to form a mortgage-crisis-like multistate taskforce to focus on the auto lending and servicing market, particularly the subprime market. A number of AGs often will come together to investigate a company for alleged violations of state law. These investigations originated in the mid-1990s when the states first joined forces to regulate the tobacco industry, not through legislation, but through investigation and regulatory enforcement. Although the federal government was not involved, the states effected significant change in the tobacco industry and its economics through a massive, industry-wide settlement. Multistate investigations usually involve a group of anywhere from a dozen states to a coalition of all U.S. jurisdictions, overseen by an executive committee comprised of the key states who constitute the driving force for that particular investigation. Although discussions between the AGs and their targets occasionally splinter into individualized litigation, the negotiation of a joint consent order or assurance of voluntary compliance, coupled with a monetary payment to the plaintiff states, more commonly occurs.
Multistates often lead to high-dollar, high-profile settlements, with states having collected many billions of dollars in the past few years. For instance, early 2017 saw a $586 million multistate settlement with Western Union to resolve allegations that the company permitted fraudulent transfers. New York has been especially active in the multistate space. In August 2016, it announced a $100 million multistate settlement with Barclays related to allegations that the bank artificially manipulated interest rates. Soon thereafter, New York AG Schneiderman announced a $714 million settlement with Bank of New York Mellon over fraudulent foreign exchange practices. The auto industry has not been immune to this force either, as varied state coalitions entered into settlements with Toyota for $29 million, as well as Hyundai and Kia for $41.2 million.
Four specific state actions may be harbingers of the future for auto finance.
In June 2017, Florida AG Pam Bondi announced a settlement with a Jacksonville car dealership, its financing arm, and its president regarding allegations that the dealership engaged in misleading business and sales practices. The consent agreement required the dealership to provide over $5 million in debt forgiveness to affected consumers.
In September 2017, Massachusetts AG Healey filed a complaint accusing JD Byrider, a used car dealership, of utilizing predatory practices in its sale of allegedly defective vehicles. According to the Commonwealth’s pleading, JD Byrider sold allegedly defective vehicles with high-cost loans to Massachusetts consumers under the “JD Byrider Program,” which bundled the vehicle sale, financing, and repair in one transaction. Healey’s office contended that JD Byrider failed to inform its customer that it priced its cars at more than double their retail value to force consumers to finance their purchase at an annual percentage rate of 19.95 percent, regardless of their credit qualifications.
Finally, New York’s AG Schneiderman announced two settlements with motor vehicle dealer groups in 2017. The settlements provided over $900,000 in restitution to approximately 6,400 consumers in the state and required the dealers to pay $135,000 in penalties and costs to the state itself for the unlawful sale of credit repair and identity-theft protection services to consumers who bought or leased vehicles. According to Schneiderman, the dealerships unlawfully sold “after-sale” credit repair and identity-theft protection services that considerably increased a vehicle’s purchase price. Consumers, Schneiderman asserted, unknowingly purchased these services, many having been led to believe that these services were free.
3. Tea Leaves
Despite Republican leadership in Washington, state AGs retain powerful tools at their disposal to help fill any void left by scaled-back federal enforcement: the ability to enforce rules previously promulgated by the CFPB; to enforce the federal Unfair, Deceptive and Abusive Acts and Practices (UDAAP) authority; and to use their own state Unfair and Deceptive Acts or Practices (UDAP) authority for consumer protection. In the legal sphere, they will continue to sue and seek individual settlements in the auto space, a sure fingerprint of their high degree of interest in and focus on the market, and will persist in considering the possibility of concerted investigations of purported violations of state consumer protection law by auto lenders.
All the while, AGs known for their regulatory activity will likely cultivate their longstanding connections with their state’s plaintiffs’ bar. As many consumer-facing companies know, state AG investigations often go hand-in-hand with class-action litigation and often concern the same claims. Many members of the plaintiffs’ bar watch for AG investigations; likewise, many members of state AG offices monitor significant consumer class action litigation.
A final portend came toward the year’s end. In October 2017, the National Consumer Law Center (NCLC) issued a report highlighting the mark-ups in add-on products during automobile sales, specifically GAP insurance and window etching. Because this report probably landed on the desks of every AG in the nation, its ripple effects could be felt for the next few years, both in consumer class litigation and investigatory actions.
This is the future that awaits the auto finance industry: increasingly active AGs, acting cooperatively, either triggering or building upon individual plaintiffs’ own suits.
II. Market Conditions
A. The Bubble Surfaces
The automobile holds a special place in this nation’s mythology and its people’s daily lives. This consumer good simultaneously serves as the primary means of transportation, essential to the survival and sustenance of countless U.S. families. Sales figures attest to its outsized role: after suffering dramatic declines during the Great Recession, U.S. vehicle sales have grown by greater increments for seven consecutive years and reached a record of $17.55 million in 2016.
The data as to the originations, outstanding balances, and delinquency rates of today’s auto loans tell the tale: as the total volume of auto loans has swelled, their terms have become longer and longer, and delinquencies have inched upwards. In terms of origination, auto loans to subprime borrowers, frequently defined as borrowers with credit scores of 660 or lower, nearly doubled from 2009 to 2014. Specifically, the percentage of used car loans that franchise auto dealers made to subprime borrowers increased from 17 percent to 25.4 percent, and new sales to subprime borrowers increased to 14 percent in 2014, comparable to prior highs in 2006 and 2007. Although lending to borrowers with lower credit scores did not expand in 2017, subprime auto lending, which all but vanished during the recession years, has now regained much of its market share.
During these years, the outstanding balances on all these loans have multiplied. In the third quarter of 2014, subprime borrowers held 39 percent, roughly $337 billion, of such loans compared to $304 billion and $255 billion in 2013 and 2012, respectively. A drop followed, but in the third quarter of 2017, auto loan balances once more increased by another $23 billion, with outstanding balances on subprime auto debt again nearing $300 billion. Holding a disproportionate share of subprime auto debt, auto finance companies currently hold more than $200 billion of such loans, double their 2011 holdings.
This upward trajectory has been matched by a noticeable ascent—if so far modest and manageable—in the general delinquency rate. For auto finance companies, this rate, already higher than the one enjoyed by conventional banks, has risen by more than two percentage points since 2004. In 2017’s first quarter, the percentage of auto loans that were over 90 days delinquent rose to 3.82 percent from 3.52 percent one year earlier, the highest level in four years. By November 2017, it reached four percent. Notably, the worsening in the delinquency rate of subprime auto loans appears most pronounced, as more than six million Americans were at least 90 days late on their auto loan repayment in 2016’s last quarter. Although the balances of subprime loans may be somewhat smaller on average, “the increased level of distress associated with subprime loan delinquencies,” the Federal Reserve Bank of New York has noted, “is of significant concern, and likely to have ongoing consequences for affected households.”
Finally, many investors are now “getting into auto loans because they have the money,” even as auto lenders have shown a revived willingness to assume greater risk. As both trends have accelerated, lenders have bundled more and more loans and created more and more securities marketed to investors and backed by the stream of payments owed by each loan’s original borrower (asset-backed securities or ABS). By late 2016, $97 billion in auto loans, with subprime loans constituting 41 percent of this total, had been securitized.
B. A Recent Parallel
One need not look too far back to find a parallel for this auto finance environment: the subprime mortgage market. Some contend that the mortgage crisis began in 2001 when the U.S. housing industry experienced an abrupt increase in the value of real estate assets to a point where consumer income to support the increase in value simply did not exist for many people. This so-called housing bubble was partly traceable to credit underwriting practices: with lenders looking beyond traditional measures of creditworthiness, a critical mass of loans went to subprime borrowers who proved unable to make their mortgage payments and subsequently defaulted on their loans. As these loans were securitized, the borrowers’ default led to massive losses in the value of the assets held by countless entities in national and international secondary markets. In 2008, the International Monetary Fund estimated that the subprime crisis led to losses totaling $945 billion in the United States alone.
On the heels of these steep losses, lenders, servicers, and owners faced a regulatory and litigation firestorm. Emblematic of the disaster was a $25 billion settlement reached in 2012 between state and federal regulators and the five largest mortgage servicers for alleged misdeeds in efforts to collect on those mortgages. Although the U.S. Department of Justice stood first in line, by all accounts the driving force of the settlement was the 49 state AGs who joined forces against the servicers.
III. Advising Clients to Plan Ahead
This is not to suggest that the situation facing the auto finance industry compares in terms of size and severity to that faced by the mortgage market in 2007 and 2008. The labor market shows low levels of unemployment, delinquency levels remain manageable, and the amount of credit outstanding is much smaller. However, historical parallels and recent state AG comments and common practices point to the distinct possibility that the auto finance industry will soon confront a mortgage-crisis-style legal environment in more than a handful of states. As a result, the question becomes how to best advise auto finance clients to minimize the risk.
Once a company finds itself in the regulatory crosshairs of a major multistate investigation, it is often too late to save money or face. The leverage and pressure that a multistate can bring to bear can make the facts and law secondary to the objectives of the state regulators. As such, the key to survival rests on one preventative action: avoid any invitation to the party in the first place. Well-known within their local communities if not the nation at large, the largest players live with a target on their back, which comes with the territory. Although the targets of a multistate can appear from the outside almost random, the reality reveals otherwise. Given clients’ mere size, their footprint, and presence, correlated to the likelihood of such scrutiny, attorneys for such entities must commit themselves to a single goal: advising any potentially impacted companies on how to establish a good reputation among regulators. Simply put, companies earn negative attention later by how they choose to act now, and a prepared attorney can steer his or her clients down a far less litigious (and expensive) path.
A four-point program, focusing on the basics, follows:
- Develop a plan. First, a smart company must plan to allay any risk of a potential firestorm. It should, for example, establish clear lines of authority for any decision making regarding a governmental inquiry, however minor, and ensure open communication (as well as encouraging cooperation) among key marketing, legal, and operations figures with actual, meaningful power, clearly demarcated. In short, no company should be unable to respond, confidently and knowingly, at a moment’s notice to a particular inquiry. Although omniscience cannot be expected, a piqued regulator or wary plaintiff should rarely encounter either persistent silence or bewildered mumbling.
- Build Regulatory Good Will with Respect and Responsiveness. History underscores the importance of positive relationships with state regulators. When such watchdogs come calling for routine examinations or to transmit a consumer complaint, a company must treat them with utmost respect and responsiveness to the extent consistent with any pendent legal concerns and dangers. Even if information must be withheld, such regard—and a good-faith explanation—may prompt a resolution or at least reduce possible acrimony. Most AGs are, after all, political actors who seek to provide dividends for their constituents and do not likely relish the prospect of open combat and uncertain rewards in the most common cases.
- Aggressively Resolve Complaints. History also teaches that a good way to avoid attention and to foster regulatory good will lies in an aggressive complaint management program. Many companies have written complaint management programs; lawyers can help develop policies for these programs targeted toward the achievement of aggressive resolution for most protests. Unresolved regulatory and consumer complaints remain likely to cause trouble. An unresolved complainant is a consumer who may be in search of a lawyer, and an unresolved complaint may cause a regulator to decide that the company cannot be trusted to police or manage itself.
- Focus on Key Areas of Technical Legal Compliance. Perhaps most importantly, the past reveals a central truth: the fundamental gripes of regulators often are not legal concerns. In the mortgage cases, for instance, regulators reacted to understandable consumer distress induced by unexpected foreclosures. Although it was not illegal to foreclose on a loan, regulators seized on technical noncompliance with one or more aspects of the myriad consumer protection laws, and used those errors as the casus belli—the formal stated reason for hostilities. To avoid this fate, a smart company must put in place the elements of compliance that a regulator would expect to see and scrub processes and documents for technical compliance, particularly those that are consumer facing.
No one can predict the future with 100-percent confidence. Regulatory trends may shift, and the economics of the auto finance industry can change without warning; however, those who fail to learn from history can be doomed to repeat it. The mortgage experience indicates that the worst can happen. Attorneys advising auto finance companies can do two things. First, message the risk internally and note the nature of the risk. Second, develop strategies to mitigate those risks. By understanding and anticipating the risks of state investigation, attorneys can prepare their clients to navigate the uncertain landscape facing auto finance companies.