March 28, 2018

Regulatory Contracts Needed to Hold Consumer Financial Bureau Accountable

J. W. Verret

Senior Affiliated Scholar

New leadership at the Consumer Financial Protection Bureau promises a whole new approach to running the agency. A new director will have the opportunity to swiftly implement a law-based approach to rule-making through rescinding guidance, changing enforcement priorities, and placing more rules through a more transparent notice and comment process. New leadership will be able to accomplish this objective in part because of the unprecedented independence and authority Congress placed in that agency.

But what’s to stop the next CFPB director from falling into politically motivated abuses of discretion? The same discretion afforded to the agency could once again be used to swing the agency’s priorities away from a rule of law approach, and away from clear guidance to help foster innovation in consumer finance. One tool the CFPB could use to cement interpretations of rules is the regulatory contract.

Consider the case of U.S. v. Winstar Corp. During the aftermath of the Savings & Loan (S&L) crisis, the Office of Thrift Supervision encouraged healthy thrifts to buy up distressed thrifts, and along the way they made promises to healthy thrifts in binding contracts about which accounting methods they could use in determining regulatory capital requirements.

Congress later changed the law, but the Supreme Court upheld the binding commitment by the Office of Thrift Supervision and awarded damages to the thrifts that relied on the promises of their regulator. This was a particularly strong case because Congress changed the law! The Supreme Court found in Winstar that the regulatory agency assumed the risk of subsequent legal change as an agent of the government in the contract.

The Supreme Court explicitly recognized the legitimacy of agency’s entering into binding contracts to accomplish regulatory objectives. Subsequent cases interpreting Winstar have been unwilling to second guess the elements of the contract, like offer, acceptance, or consideration, and instead err in favor of holding government agencies to their regulatory contracts.

The government is held to a high standard in regulatory contracts, and even when underlying promises are found to involve technical violations of law, the regulated party often wins anyway. The court reasons that the government is in a better position to interpret the law than the regulated party, and the government is held to a high standard of good faith dealing.

One way in which regulatory contracts could prove particularly useful at the CFPB is in creating a healthy “regulatory sandbox” for new innovators in consumer finance. The CFPB previously introduced “Project Catalyst” to encourage innovators to come to the CFPB and get assurance about how laws would not unintentionally impede new innovations in finance that were not anticipated in prior regulations. Similar regulatory sandbox approaches have proved successful in the United Kingdom. And yet Project Catalyst has catalyzed very little; industry participants report their fear that the CFPB might later reverse course and use information obtained through Project Catalyst against them in an enforcement action.

That problem will remain under the new administration. Regulatory contracts could provide the assurance and predictability that Project Catalyst was intended to introduce.

This is certainly not an optimal approach to governance. Ideally agencies would put clear rules through a transparent notice and comment process. They should conduct objective cost-benefit analysis of those rules to ensure new rules do not diminish consumer access to credit. They shouldn’t bring enforcement actions based on erroneous interpretations of law. The CFPB has been subject to critiques for failure to meet all of those standards from both Republicans and Democrats since. Under future leadership it may commit the same infractions.

The CFPB could adopt a number of policies to ensure transparency in the regulatory contracting process. For example, the agency could put its process for reviewing regulatory contracts through a public notice and comment process. It could further put individual regulatory contracts through notice and comment. It could publicize the standard language it intends to include in regulatory contracts.

Companies that provide funding to main street businesses and are eager to follow the law, but to do that, they need to know what the law requires. Regulatory contracts are a useful and legitimate tool to bind the CFPB to its commitments to regulated entities. They have been successfully used by banking regulators in the past and should be considered as a helpful tool in the CFPB’s regulatory toolbox going forward.