Material Interference in UDAAP Lawsuit

QUESTION 

We are being sued for a violation of UDAAP. The lawsuit is based on the allegation that we materially interfered with the ability of a consumer to understand our terms and conditions. As far as I know, we have never intentionally misled a consumer. Our legal counsel is fighting back, but our reputation is already getting hit with negative press. 

I am the Chief Operating Officer, and with permission of our Board, I am writing you to ask for some history involving this kind of allegation. Your response could help us broaden our perspective and assist us in making sure this incident never happens again. 

We recently signed up for your UDAAP Tune-up, but it will not start for a few weeks. In the meantime, a word from you about some facets of this allegation would be appreciated. 

What is "material interference" involving terms and conditions in the context of UDAAP? 

ANSWER 

Thank you for your interest in our UDAAP Tune-up. Our UDAAP review is in demand. When it comes to Unfair, Deceptive, or Abusive Acts or Practices (UDAAP), it is essential to be proactive. Don’t wait for a regulatory investigation; certainly, don’t think you can wiggle your way out of a lawsuit, which often metastasizes into class action litigation. 

You can have your counsel contact me to discuss your case explicitly if they want expert witness support. 

There are many litigious access points to allege UDAAP violations, given that many regulatory frameworks are implicated.[i] You mentioned that you never intended to mislead the consumer; however, it is important to recognize that intent is not required to show material interference. 

Brief History

In 2010, Congress passed the Consumer Financial Protection Act of 2010 (CFPA) and banned abusive conduct.[ii] The CFPA's prohibition on abusive conduct was the most recent congressional tailoring of the Federal prohibitions to ensure fair dealing and protect consumers and market participants in the United States. 

The 2007-2008 financial crisis tested consumer protection laws, government watchdogs, and the ability of the existing authorities to address predatory lending, considered to be a primary cause of the collapse. The financial crisis was set in motion by avoidable interlocking forces. At its core were mortgage lenders profiting (by selling on the secondary market) on loans that set people up to fail because they could not repay. 

Consequently, Congress concluded that federal agencies' enforcement of the prohibitions on unfair and deceptive acts or practices was too limited to be effective at preventing the financial crisis. Therefore, it amended existing law. This is the point at which the FDIC, in 2007, said the term “unfairness” is a restrictive legal standard and the term “abusive” should be added because it is more legally flexible.[iii] In the CFPA, Congress granted authority over unfair or deceptive acts or practices to the states, the Federal banking agencies, and the newly created Consumer Financial Protection Bureau (CFPB). Congress also added a prohibition on abusive acts or practices. 

There have been numerous updates to the regulatory supervision and enforcement of UDAAP over the years. Indeed, since the enactment of the CFPA, government enforcement and supervisory agencies have taken dozens of actions to condemn prohibited abusive conduct. Earlier this year,  the CFPB issued a Policy Statement to summarize those actions and explain how the Bureau analyzes the elements of abusiveness through relevant examples. This Policy Statement is the CFPB’s first formal issuance that summarizes precedent on abusive acts or practices and provides an analytical framework for identifying abusive acts or practices.[iv] 

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For information about our UDAAP Tune-up, please contact us here.

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I will provide a cursory overview of the CFPA prohibitions. Thereafter, I’ll briefly explain the prohibition regarding “material interference” as it relates to terms and conditions.

Overview 

Under the CFPA, there are two abusiveness prohibitions.[v] An abusive act or practice: 

(1) Materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service, or 

(2) Takes unreasonable advantage of: 

·       A lack of understanding on the part of the consumer of the material risks, costs, or conditions of the product or service; 

·       The inability of the consumer to protect the interests of the consumer in selecting or using a consumer financial product or service; or 

·       The reasonable reliance by the consumer on a covered person to act in the consumer's interests. 

The statutory text of these two prohibitions may be summarized at a high level as:

 

(1) obscuring important features of a product or service, or

 

(2) leveraging certain circumstances to take an unreasonable advantage. The circumstances, or three prongs, that Congress set forth generally concern gaps in understanding, unequal bargaining power, and consumer reliance.[vi] 

Unlike unfairness but similar to deception, abusiveness requires no showing of substantial injury to establish liability but is focused on conduct that Congress presumed to be harmful or distorts the proper functioning of the market. Put otherwise, an act or practice need only fall into just one of the categories above to be abusive, but an act or practice could fall into more than one category.[vii] 

Material Interference in Terms and Conditions 

The first abusive act or practice that takes unreasonable advantage of consumers, gaps in understanding, concerns situations where an entity “materially interferes with the ability of a consumer to understand a term or condition of a consumer financial product or service.”[viii] Material interference may be shown when an act or omission is intended to impede consumers’ ability to understand terms or conditions, has the natural consequence of impeding consumers’ ability to understand, or actually impedes understanding. 

Acts or omissions may be material interference. Material interference may include actions or omissions that obscure, withhold, de-emphasize, render confusing, or hide information relevant to the ability of a consumer to understand terms and conditions. Interference can take numerous forms, such as “buried disclosures,” physical or digital interference, “overshadowing,” and various other means of manipulating consumers’ understanding. 

What is a buried disclosure? It is a disclosure that limits people’s comprehension of a term or condition, including, but not limited to, fine print, complex language, jargon, or the timing of the disclosure. There could be an oral component, too.[ix] Entities can also interfere with understanding by omitting material terms or conditions. 

There may be physical interference, where physical conduct impedes a person’s ability to see, hear, or understand the terms and conditions, including, but not limited to, physically hiding or withholding notices.[x] 

Digital interference may occur where there are impediments to a person’s ability to see, hear, or understand the terms and conditions when presented to someone in an electronic or virtual format. This form of interference includes, but is not limited to, user interface and user experience manipulations, such as the use of pop-ups or drop-down boxes, multiple click-throughs, or other actions or “dark patterns” that have the effect of making the terms and conditions materially less accessible or salient.[xi] 

Material interference includes a process of overshadowing, which is the prominent placement of certain content that interferes with the comprehension of other content, including terms and conditions.[xii] 

Facing Litigation 

There are several methods to prove material interference with a consumer’s ability to understand terms or conditions. My response focuses on the prong of leveraging certain circumstances to take unreasonable advantage of consumers, to wit, gaps in understanding, but the other two prongs, unequal bargaining power, and consumer reliance, may also be implicated in material interference litigation.     

First, while intent is not required to show material interference, it is reasonable to infer that an act or omission materially interferes with consumers’ ability to understand a term or condition when the entity intends it to interfere.[xiii] 

Second, material interference can be established with evidence that the act or omission's natural consequence would impede consumers’ ability to understand. 

And third, material interference can also be shown with evidence that the act or omission did, in fact, impede consumers’ actual understanding. 

While evidence of intent would provide a basis for inferring material interference under the first method, it is not a required element to show material interference. 

Certain transaction terms are so consequential that when not conveyed to people prominently or clearly, it may be reasonable to presume that the entity engaged in acts or omissions that materially interfere with consumers’ ability to understand. That information includes, but is not limited to, pricing or costs, limitations on the person’s ability to use or benefit from the product or service, and contractually specified consequences of default. 

An entity’s provision of a product or service may interfere with consumers’ ability to understand if the product or service is so complicated that material information about it cannot be sufficiently explained or if the entity’s business model functions in a manner that is inconsistent with the apparent terms of its products or services. 

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

Artificial Intelligence: Benefits and Risks

QUESTION 

There has been a lot of news about artificial intelligence. I have to admit, I do not know anything about it. Yet my company has just announced that it is linking up with an artificial intelligence provider. 

Now, we are scrambling to understand how artificial intelligence will impact our jobs, loan process, and compliance requirements. Last year, nobody cared about AI. This year, it’s all they can talk about! 

I would like you to tell us some ways that AI is used by banks and nonbanks, since providing compliance to us is your specialty. We need some basic understanding of how AI will be a part of originating and servicing loans. 

What are some ways that financial institutions are using AI? 

ANSWER 

I sense your frustration, and you are not alone. Whenever a new technology or innovation enters the marketplace, there is a perfectly normal tendency to be a bit suspicious and even worried about its implications. In time, these concerns often become resolved, sometimes with less than optimum impact on society, sometimes with far-reaching positive impact. The challenge is anticipating change and preparing proactively to mitigate unwanted outcomes. 

I don’t think financial institutions should rush into Artificial Intelligence (“AI”) without first considering compliance. But, there are good reasons to implement AI as a tool in the quest for a strong compliance program. When planning to partner with an AI vendor, it is important to bring in a firm such as ours to provide reliable due diligence to ensure the compliance component is integral to the plan. This creates a “baseline” that serves to enhance policies and procedures, training, and ongoing improvements in the technological application. 

Many banking agencies have been vetting AI for a few years. They're still in the early stages of drafting the rulemaking, but there has been an increase in regulatory guidance issuances. As a provider of customized compliance libraries, we are updating our clients’ policies for such guidance. And when rulemaking is determined, we will provide an AI policy, specific to a client's needs, and prior to a promulgated effective compliance date. 

Five banking agencies (OCC, FRB, FDIC, CFPB, and NCUA) have sought information and comments on the use of AI, including machine learning, by financial institutions. The caveat thus far is that they support responsible innovation as long as it includes identifying and managing associated risks. 

We can glean the areas of scrutiny being reviewed for supervision, examination, and enforcement by taking note of the following ways financial institutions use or may use AI. Though not meant to be a comprehensive outline, based on our interactions with regulators and published issuances, I’m sure these areas are under review for AI compliance. 

ARTIFICAL INTELLIGENCE: BENEFITS

Flagging Unusual Transactions 

Many institutions use AI to identify potentially suspicious, anomalous, or outlier transactions (for instance, fraud detection and financial crime monitoring). This involves using different forms of data (i.e., email, texts, audio data – both structured and unstructured)[i] to identify fraud or anomalous transactions with greater accuracy and timeliness. It also includes identifying transactions for Bank Secrecy Act/Anti-Money Laundering activities, monitoring employees for improper practices, and detecting data anomalies. 

Personalization of Customer Services 

Institutions use AI technologies, such as voice recognition and Natural Language Processing (NLP),[ii] to improve the customer experience and increase efficiency in allocating financial institution resources. 

One example is using chatbots[iii] to automate routine customer interactions, including account opening activities and general customer inquiries. AI is leveraged at call centers to process and triage customer calls to provide customized service. Institutions also use these technologies to target marketing better and customize trade recommendations. 

Credit Decisions 

Some institutions use AI to inform credit decisions to enhance or supplement existing techniques. This application of AI may use traditional data or employ “alternative data”[iv] (such as cash flow transactional information from a bank account). 

Risk Management 

Institutions may use AI to augment risk management and control practices. For example, an AI approach might be used to complement and provide a check on another, more traditional credit model. Financial institutions may also use AI to enhance credit monitoring (including through early warning alerts), payment collections, loan restructuring and recovery, and loss forecasting. 

AI can assist internal audit and independent risk management to increase sample size (such as for testing), evaluate risk, and refer higher-risk issues to human analysts. Indeed, AI may also be used in liquidity risk management, for example, to enhance monitoring of market conditions or collateral management. 

Textual Analysis 

Textual analysis refers to using NLP for handling unstructured data (generally text) and obtaining insights from that data or improving the efficiency of existing processes. Applications include analysis of regulations, news flow, earnings reports, consumer complaints, analyst ratings changes, and legal documents. 

Cybersecurity 

Institutions may use AI to detect threats and malicious activity, reveal attackers, identify compromised systems, and support threat mitigation. Examples abound, including real-time investigation of potential attacks, the use of behavior-based detection to collect network metadata, flagging and blocking of new ransomware and other malicious attacks, identifying compromised accounts and files involved in exfiltration, and deep forensic analysis of malicious files. 

There are risks, too, which I’ll explain shortly. But, it should be obvious that the agencies recognize that AI has the potential to offer improved efficiency, enhanced performance, and cost reduction for financial institutions, as well as benefits to consumers and businesses. AI can identify relationships among variables that are not intuitive or not revealed by more traditional techniques. And it can better process certain forms of information, such as text, that may be impractical or difficult to process using traditional methods. 

AI also facilitates processing significantly large and detailed datasets, both structured and unstructured, by identifying patterns or correlations that would be impracticable to ascertain otherwise.

In general, other potential AI benefits include more accurate, lower-cost, and faster underwriting and expanded credit access for consumers and small businesses that may not have obtained credit under traditional credit underwriting approaches. AI applications may also enhance an institution’s ability to provide products and services with greater customization. 

ARTIFICAL INTELLIGENCE: RISKS

But there are risks. The agencies have emphasized that financial institutions should have processes to identify and manage the potential risks associated with AI. Many of the risks associated with using AI are not unique to AI. For example, using AI could result in operational vulnerabilities, such as internal process or control breakdowns, cyber threats, information technology lapses, risk associated with using third parties, and model risks, all of which could affect an institution’s safety and soundness. 

Furthermore, the use of AI could also create or increase consumer protection risks, such as risks of unlawful discrimination, unfair, deceptive, or abusive acts or practices (UDAAP) under the Dodd-Frank Act, unfair or deceptive acts or practices regulation (UDAP) under the FTC Act, or privacy concerns.

The agencies have identified three risks particular to AI: 

• Explainability, 
• Data Usage, and 
• Dynamic Updating. 

Here’s a brief explanation of each risk. 

Explainability 

“Explainability” refers to how an AI approach uses inputs to produce outputs. In other words, some AI approaches can exhibit a “lack of explainability” for their overall functioning (sometimes known as global explainability) or how they arrive at an individual outcome in a given situation (sometimes referred to as local explainability). 

Lack of explainability can pose different challenges in different contexts. Lack of explainability can also inhibit a management’s understanding of the conceptual soundness of an AI approach (that is, the quality of the theory, design, methodology, data, developmental testing, and confirmation that an approach is appropriate for the intended use) which, then, can increase uncertainty around the AI approach’s reliability, and increase risk when used in new contexts. 

Lack of explainability can also inhibit independent review and audit and make compliance with laws and regulations, including consumer protection requirements, more challenging. 

Data Usage 

Broader or more intensive data usage plays a particularly important role in AI. In many cases, AI algorithms identify patterns and correlations in training data without human context or intervention and then use that information to generate predictions or categorizations. 

Because the AI algorithm depends on the training data, an AI system generally reflects any dataset limitations. As a result, as with other systems, AI may perpetuate or even amplify bias or inaccuracies inherent in the training data or make incorrect predictions if that data set is incomplete or non-representative. 

Dynamic Updating 

Some AI approaches have the capacity to update on their own, sometimes without human interaction, often known as dynamic updating. Monitoring and tracking an AI approach that evolves on its own can present challenges in review and validation, particularly when a change in external circumstances (i.e., economic downturns and financial crises) may cause inputs to vary materially from the original training data. 

Dynamic updating techniques can produce changes that range from minor adjustments to existing elements of a model to the introduction of entirely new elements. 

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] The term “structured data” generally refers to a set of data that has been systematically organized or arranged.

[ii] “Natural Language Processing” or “NLP” generally refers to the use of computers to understand or analyze natural language text or speech.

[iii] The term “chatbot” generally refers to a software application used to conduct an on-line chat conversation via text or text-to-speech, in lieu of providing direct contact with a live human agent.

[iv] “Alternative data” means information not typically found in the consumer’s credit files of the nationwide consumer reporting agencies or customarily provided by consumers as part of applications for credit.

Snollygosters and Throttlebottoms

QUESTION 

I have been reading about the CFPB coming under attacks as being unconstitutional. If it is found to be unconstitutional, we are concerned about everything it has done all these years, such as whether we are going to still be required to follow all its rules and regulations. 

It seems to me the politicians who created the CFPB should have thought of its constitutionality before setting it up in the first place. We send them to Congress, they create the CFPB, and then it is found to be unconstitutional years later. I think that could affect the whole shebang of policies my company put in place for years at a huge expense. 

I'm no lawyer but most of these Congress critters are lawyers. They should know how to write a constitutional law. I am frustrated. I am concerned about CFPB enforcement, too. Especially at this time, I do not have the money to reset our policies to pre-CFPB conditions if the CFPB's authority is destroyed. 

I have read your articles for years. I know you can explain what is going on. 

What are the implications of the CFPB being considered unconstitutional? 

ANSWER 

I have received many questions along the lines of your inquiry. Quit paying so much attention to snollygosters who prey on your fears. Fear gets people fired up, which is the point of it all. Then they get all charged up, go out to vote, and, lo and behold, they elect the fearmongering throttlebottoms who proceed to screw up the machinery with anfractuous, circuitous, serpentine, and tortuous crepitations of impending apocalypse. 

Let's dispense with the realm of signs, portents, and omens. 

So, first and foremost, take a deep breath. The CFPB's rules are not going anywhere for now. However, there are some litigation challenges along the way that will need to be vetted. 

A few weeks ago, on October 19, 2022, three judges in the Fifth Circuit Court of Appeals ruled that the funding mechanism of the Consumer Financial Protection Bureau (CFPB) is unconstitutional.[i] Specifically, the court found it was a violation of the Appropriations Clause[ii] of the Constitution for the CFPB to receive funds upon the CFPB Director's request to the Federal Reserve instead of through Congressional appropriations. 

The instant case involves a challenge to the validity of the payment provisions of the CFPB's 2017 Payday Lending Rule ("Rule"). Under the Rule, lenders are prohibited from making payment transfers from consumer accounts after two consecutive failed attempts due to insufficient funds unless the consumer authorizes such attempts. 

The district court granted summary judgment in favor of the CFPB. But, on appeal, the plaintiffs challenged the CFPB's promulgation of the Rule, alleging that the Rule was promulgated by a Director who could not be removed, which means the Director is "insulated" from removal. (I'll come back to the implications of the Director being "insulated" momentarily.) The plaintiffs further alleged that the CFPB's rulemaking itself is violative of the non-delegation doctrine and that the CFPB's means of receiving funds violates the Appropriations Clause. 

The non-delegation doctrine stems from the Constitution's vesting clause and separation of powers. The doctrine is an interpretation derived from Article I, Section I of the Constitution that declares all legislative power granted by the Constitution is vested in the Congress, the legislative branch. Thus, it's a principle in administrative law that holds Congress cannot delegate its legislative powers to other entities, such as delegating its power to administrative agencies or private organizations. 

The court said that the way the CFPB receives funds allows the CFPB to have a "double insulation" from the Congressional appropriation power: the CFPB Director's requesting funds from the Federal Reserve, which the Director deems "to be reasonably necessary," violates Congress's appropriations power. 

Furthermore, the court reasoned that the Federal Reserve itself falls outside of Congress's appropriations power because it receives funds from bank assets not subject to review by the House or Senate Committee on Appropriations. 

Therefore, the court found that Congress's authorization of the CFPB to promulgate the Rule was not unconstitutional, but the CFPB improperly used unappropriated funds to engage in the rulemaking process. In its reasoning, the court clarified that the CFPB lacked the ability to exercise the power to promulgate the Rule through constitutionally appropriated funds. 

In my view, this ruling will not have much or any impact on the structure of the CFPB. The court's ruling focuses on how the CFPB receives its funding and its violation of the Appropriations Clause. I think it's unlikely that this case will have any effect on the CFPB's enforcement powers as a regulatory agency. 

That word "unlikely" is doing a lot of work there. I happen to think the CFPB's funding mechanism is constitutional under the Appropriations Clause; in fact, the CFPB must ask Congress for any money it receives out of the Treasury, which goes for several other federal agencies operating similarly, including the FDIC. 

The court must recognize the potentially devastating consequences that could result from interfering with the funding practices of all independently funded government agencies. We know this because the court specifically limited its reasoning to the CFPB. It did this juridical prestidigitation by claiming that the CFPB's authority is unlike those of other federal regulators and that its funding independence "goes a significant step further." How it goes a "significant step further" is somewhat of a mystery. 

I fail to see the difference. And if there is a difference, the court does not bother to explain why those differences are constitutionally significant, as far as I can tell. 

As the Constitutional Accountability Center has stated:

"Despite the court's attempt to carve out a special rule for the CFPB, its reasoning would seemingly apply to the host of other financial regulators that are independently funded, including the Federal Reserve Board, which supervises and regulates numerous banking institutions."[iii]

So, the court has put the CFPB and many similarly funded agencies into a reductio ad absurdum conundrum since it now calls into question the rules, guidance, and orders that the CFPB and the other agencies have issued, inasmuch as they are similarly funded like the CFPB. For instance, agencies similarly funded outside the congressional appropriations process are the Federal Reserve, Federal Deposit Insurance Corp (FDIC), Office of the Comptroller of the Currency (OCC), National Credit Union Administration (NCUA), and Federal Housing Finance Agency (FHFA). 

The ruling attempts a surgical clip but winds up taking a machete to many agencies. 

Indeed, the CFPB has already stated that the Fifth Circuit's decision is "neither controlling nor correct" and "mistaken." The CFPB has stated, "there is nothing novel or unusual about Congress's decision to fund the CFPB outside of annual spending bills."[iv] 

This past Monday, November 14^th, the CFPB petitioned for a writ of certiorari to the U. S. Supreme Court, saying that the Fifth Circuit’s decision "threatens to inflict immense legal and practical harms on the CFPB, consumers, and the nation’s financial sector.”[v] 

The CFPB should now request a stay from the Fifth Circuit pending the Supreme Court decision, or, if denied by the Fifth Circuit, it should ask for a stay from the Supreme Court. If the CFPB doesn’t get a stay, it is not unreasonable to conclude that the Fifth Circuit’s decision could impede the CFPB’s litigating of current cases while also potentially impacting past enforcement actions and rulemaking.[vi]

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director

Lenders Compliance Group

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[i] Community Financial Services Association of America, Limited; Consumer Service Alliance of Texas v Consumer Financial Protection Bureau; Rohit Chopra, in his official capacity as Director, Consumer Financial Protection Bureau, United States Court of Appeals for the Fifth Circuit, Case 21-50826

[ii] Article I, Section 9, Clause 7, U. S. Constitution: “No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.”

[iii] As Wrong as It is Dangerous: The Fifth Circuit’s Decision Holding the CFPB Funding Structure Unconstitutional, Constitutional Accountability Center, https://www.theusconstitution.org/blog/blog-as-wrong-as-it-is-dangerous-the-fifth-circuits-decision-holding-the-cfpb-funding-structure-unconstitutional

[iv] Appeals court finds CFPB funding unconstitutional, Katy O'Donnell, October 19, 2022, statement to Politico from CFPB spokesperson Sam Gilford. https://www.politico.com/news/2022/10/19/appeals-court-cfpb-unconstitutional-00062626

[v] Consumer Financial Protection Bureau, Et Al, v Community Financial Services Association of America, Limited, Et Al, Petition for a Write of Certiorari, November 14, 2022, section Reasons for Granting the Petition, p. 10

[vi] Ibid. Reasons for Granting the Petition, Section B. The Decision Below Warrants Review, And The Court Should Hear The Case This Term, p. 28