Consumer Protection Settlements: Theory and Policy Issues

In a new paper, I compare private and public class action settlements. I find a dearth of theoretical law and economics literature on public class actions, so I use the private class actions literature and a pivotal case study to highlight key issues and suggest areas for future research.

Class Actions Are Different. Class actions are quite different from other lawsuits. Frequently an attorney initiates the action rather than a plaintiff, and there is no formal relationship with members of the class.  There are clear economies of scale in class actions, and the plaintiffs’ attorneys perform a socially useful function by helping to deter undesirable conduct and by allowing clients to receive legal representation without major transactions costs.

Often there is no class member with a sufficient stake to create an incentive to monitor the attorneys’ behavior. Since the attorneys bear most of the costs of litigation, they are at risk if the case goes to trial. Hence, U.S. law sometimes allows these attorneys to settle class actions over the objections of some clients. This creates an important difference between the clients’ and the attorneys’ incentives to settle, and the attorneys’ incentives typically determine the result. Clients are dispersed, and their individual damages may be small. Scholars have developed models to show how courts can prevent attorneys from manipulating the settlement to their own advantage.

Pareto Optimal Settlements. Economists use the concept of Pareto optimality to delineate conditions in which one party cannot be made better off without other parties being made worse off. In the legal settlements literature, if two litigants have symmetric information – each knows the expected outcome if there is a trial – attorneys can structure a settlement to avoid further costs of litigation and allow the parties to split the “bargaining surplus.” Clearly, the cost of litigation is a deadweight loss for the litigants. This idea has been taught in law and economics courses at U.S. law schools for decades. No doubt as a result, one scholar reported in 2007 that only 4 percent of private lawsuits filed in state courts go to trial and for federal courts the figure is only 2 percent.  While economists recognize that the plaintiff is often unhappy about settling for less than she considers to be the true economic damages, and the defendant is not overjoyed about paying more than he thinks he should owe, these types of settlements are considered Pareto optimal.

The result is quite different – and much more challenging in terms of the economic modeling – under conditions of asymmetric information. If the parties have very different expectations of the outcome at trial, settlement is much less likely. One very important issue is the source of the asymmetric information. An increase in the amount at stake decreases the likelihood of settlement. Various legal rules can increase information asymmetry and reduce the probability of settlement. Legal rules that affect the allocation of legal costs also often reduce the likelihood of settlement, but rules requiring discovery reduce asymmetric information and thereby increase the likelihood of settlement. Asymmetric information determines which cases will be selected for litigation, and asymmetric information affects the settlement process and the settlement amount.

Since asymmetric information makes the possibility of trial more likely, the actual level of litigation exceeds the socially optimal level. A party causing injury and making a settlement offer does not know the true harm, so victims with relatively high harm will reject the offer and go to trial. One empirical study finds no evidence of asymmetric information in a database of litigation outcomes, but another does find such evidence. None of these studies deals with class action settlements.

Two Cases.  I contrast the pivotal case, United States v. Fairbanks Capital Corporation, which was resolved very quickly in 2004, with another case, Consumer Financial Protection Bureau v. Ocwen Financial Corporation (2020). Both cases involved mortgage servicing. Servicers collect payments from homeowners, keep records of mortgage balances, pool the payments, remit principal and interest to investors, and manage escrow accounts. A well-functioning mortgage servicing industry is essential to the health of the financial system. If investors in mortgage backed securities cannot report the value of these assets accurately, confidence in the financial system will be damaged, which is precisely what happened during the 2007-09 financial crisis.

As a servicer of subprime mortgage loans, Fairbanks dealt primarily with financially unsophisticated individuals. The firm was accused of numerous violations of state and federal law in class action lawsuits in at least 10 states and in several thousand individual lawsuits. Allegations included violations of the Fair Debt Collection Practices Act (FDCPA), the Real Estate Settlement Procedures Act (RESPA), the Truth in Lending Act (TILA), the Federal Trade Commission (FTC) Act, various state consumer protection laws, deceptive, unfair, and unconscionable debt collection practices, and assessing fictitious fees. One common allegation was that Fairbanks held monthly payment checks from borrowers until after the 15-day grace period to impose a late fee (often 5 percent of the monthly payment). Unpaid late fees cause the next monthly payment to be insufficient, triggering a pyramiding of late fees and possible foreclosure. Fairbanks was also accused of misapplication of borrowers’ funds, placing money in suspense accounts at no interest for over a year, charging borrowers for unnecessary insurance, charging improper prepayment penalties, and a variety of similar practices.

The federal government sued Fairbanks for the same practices, consolidated all the state cases and settled immediately. Fairbanks did not admit wrongdoing, but the settlement required changes in its operations and the creation of a $40 million redress fund for the benefit of affected borrowers to remedy the violations of law alleged by the FTC and HUD. The founder and former CEO of Fairbanks was required to pay a personal fine of $400,000 into the fund. HUD Secretary Mel Martinez stated that Fairbanks had “engaged in a laundry list of predatory loan servicing practices,” and called it a “record settlement.” I show that “record settlement” is a curious statement. The $40 million settlement amount is small in comparison with later settlements related to mortgage market abuses, many of which are for amounts over $10 billion. In May 2004 the settlement was approved by the court.

Objections to the settlement noted that Fairbanks would receive a broad release of liability and that many class members would receive minimal cash payments, estimated at less than $200 in many cases. The objections also pointed out that many class members entitled to relief would receive nothing if they did not respond to the one notice that was sent, that many class members who had moved (such as those who had lost their homes through unjustified foreclosure) would not receive any notice at all, that all discovery in the case was under seal, that class members who accepted the settlement were prohibited from speaking to the press about any aspect of the case, and that the notice provided little financial information to allow borrowers to make an informed judgment as to whether to participate. More than 1,100 borrowers opted out of the settlement, presumably in most cases to pursue individual lawsuits.

In a “Modification” of the 2003 settlement in 2007, the FTC stated that it had evaluated Fairbanks’ compliance with the provisions of the 2003 settlement. The modified 2007 settlement contains an extremely long list of prohibited practices, many of which were the same practices that were prohibited by the original settlement. This suggests that Fairbanks had failed to comply with many of the terms of the original agreement, including those related to foreclosure and the failure to provide accurate and timely information to borrowers about amounts owed. The “Modification” logically raises serious questions about the original settlement’s effectiveness. Importantly, Fairbanks executives could have simply anticipated settlement costs and estimated that their “project” nonetheless had a positive net present value.

Ocwen also specialized in subprime loans; it had grown its servicing portfolio substantially by acquisition, from about 350,000 loans ($50 billion) in 2010 to 2.9 million loans ($465 billion) in 2014, despite not being able to service these loans properly. The U.S. Consumer Financial Protection Bureau cited one internal communication that called Ocwen’s technology “an absolute train wreck,” while another stated the company’s systems made it impossible to comply with applicable laws and regulations. There are allegations of missing documents, improperly calculated loan balances, misapplied payments, unverified transferred loans, inaccurate payment histories, and failure to respond to consumer complaints. As of January 2021, Ocwen continued to be at odds with the CFPB.  The way this case was handled more closely reflects my preferred policy recommendation of not settling quickly, not settling until problems are resolved, and (hopefully) not until victims are compensated fairly.

Policy Implications. First, since a firm considering predatory activity directed at financially unsophisticated consumers would rationally build an estimate of expected settlement costs into an analysis of the profitability of the project, it is important for consumer protection regulators and judges to attempt to determine the intent of the defendant before structuring or approving a settlement. Lawsuits have a deterrent effect which is mitigated if settlements are routine. Deliberate predatory activity may constitute fraud and should be treated as such. Second, the dollar amount of settlements negotiated by an agency is not necessarily a good measure of the agency’s effectiveness in consumer protection. If the predatory firm anticipated settlement, an emphasis on the value of settlements could validate the predator’s actions and may encourage future predatory behavior. Third, the regulator has an information advantage and should use it. Asymmetric information, superior resources, and the authority to do extensive discovery may make the consumer protection regulator the best representative of the class if the regulator is motivated to represent the class fairly.

Scholars have raised concerns about the ethics and efficacy of public settlements. Further, there is a view in the law and economics literature that settlements reduce the deterrent effect of litigation. My analysis is consistent with that literature.

This post comes to us from Emeritus Professor James E. McNulty at Florida Atlantic University. It is based on his recent article, “Consumer Protection Settlements: Theory and Policy,” available here.