10 minute read | September.17.2020
The Department of Housing and Urban Development earlier this month issued a final disparate impact regulation under the Fair Housing Act (Final Rule). HUD’s new Final Rule is intended to align its disparate impact regulation, adopted in 2013 (2013 Rule), with the Supreme Court’s 2015 ruling in Texas Department of Housing and Community Affairs v. Inclusive Communities Project, Inc. (Inclusive Communities). While the new Final Rule is a notable development, the relatively recent Supreme Court decision makes it unclear to what extent courts and federal agencies will look to the rule for guidance.
The Supreme Court’s 2015 ruling in Inclusive Communities (covered at the time in a Special Alert) did not directly invalidate HUD’s 2013 Rule, but it set substantially more difficult standards for plaintiffs seeking to use a disparate impact theory under the FHA. HUD’s new Final Rule, which largely follows last year’s proposal (covered by InfoBytes here), represents its effort to codify “safeguards” contemplated by Inclusive Communities and other disparate impact case law — and in doing so, to create new uniform standards for determining when a policy or practice has a discriminatory effect in violation of the FHA. But the Supreme Court’s decision not to defer to the agency’s earlier interpretation of the standards has left judges, agencies, and plaintiffs alike to question whether they should rely upon the Final Rule or hew to the lines drawn in Inclusive Communities.
At the heart of the Final Rule are a modification of the three-step burden-shifting framework in its 2013 Rule, several new elements that plaintiffs must show to establish that a policy or practice has a “discriminatory effect,” and specific defenses that defendants can assert to refute disparate impact claims.
HUD states that the new rule will ensure a “balanced approach” to disparate impact litigation by “providing a roadmap for plaintiffs” to “assist in navigating the limitations that courts have placed on such claims” while “protecting against frivolous lawsuits.” While HUD asserts that the final rule “does not set a higher standard than the one currently used by most courts,” that is likely because most courts have heeded the limitations on disparate impact set forth in the 2015 Inclusive Communities decision rather than allowing plaintiffs to use the more expansive standards set forth in the 2013 Rule. Put simply, while the new final rule places more of an onus on plaintiffs seeking to prove discrimination when bringing disparate impact claims against lenders, landlords, developers, housing authorities, or other potential defendants in FHA cases than did the 2013 Rule, it is not clear whether the new rule raises the bar higher than the Supreme Court already raised it in Inclusive Communities. The final rule also clarifies HUD’s position with respect to remedies in the disparate impact context and codifies HUD’s position that its rule is not intended to infringe on the states’ regulation of insurance.
Five elements for establishing discriminatory effect under the FHA
HUD’s final rule modifies the prior burden-shifting framework to place more onus on the plaintiff in establishing a prima facie case of a discriminatory effect under the FHA.
Under the new rule, the plaintiff must plead five separate elements with respect to the challenged policy or practice. Specifically, under the new rule, a plaintiff must identify a specific policy or practice, and then plead that the challenged policy or practice:
Stemming from the Supreme Court’s concern that relevant standards should incorporate safeguards to ensure that the disparate impact suits do not displace “valid governmental or private priorities” but rather solely remove artificial, arbitrary, and unnecessary barriers, the Final Rule’s first element requires the plaintiff to plead that the challenged policy or practice is “arbitrary, artificial, and unnecessary” in order to establish a claim. Thus, under the Final Rule, plaintiffs will need to assess whether the challenged policy or practice has a “facially legitimate objective” and, if so, must allege facts at the pleading stage sufficient to support a plausible allegation that the practice is “arbitrary, artificial, and unnecessary” to achieve a valid interest. On the other hand, where the plaintiff does not know and the policy’s objective is not clear on its face, the plaintiff can assert that there is “no obvious legitimate objective.” In line with its August 2019 proposal, HUD reiterated that plaintiffs “may lose their disparate impact case at the pleading stage” for identifying a “one-time decision” that is not a policy.
The defendant may rebut the plaintiff’s allegation under this first element by producing evidence showing that the challenged policy or practice advances a “valid interest (or interests)” and is thus not arbitrary, artificial, and unnecessary. If the defendant so rebuts, the plaintiff must prove by a preponderance of evidence that the interest(s) advanced by the defendant are not valid or that a less discriminatory policy or practice exists that would serve the same interest(s) in an “equally effective manner without imposing materially greater costs on, or creating other material burdens for, the defendant.” If courts and agencies look to the standards in the new rule, the requirement that a less discriminatory alternative be “equally effective” could be very significant.
The burden of proof is on the plaintiff to establish by the preponderance of the evidence each of the remaining four elements. All five elements largely remain substantively the same as the ones provided for in the August 2019 proposed rule, except that the adverse effect element was slightly modified by the addition of the term “disproportionately” to clarify that the plaintiff must show that protected class members are disproportionately more likely to be affected than individuals outside the protected class. The final rule also clarifies that the proposal’s use of the term “material” in connection with the “significant” disparity element was not intended to import a materiality requirement; rather, the significance requirement is purposefully undefined, designed to “vary from cases to case” and, depending on the situation, could entail elements of both a statistical test and a test of the amount of impact a policy has.
Enumerated disparate impact defenses
The 2013 Rule did not enumerate any defenses available to the defendant in connection with disparate impact claims other than the ability to assert a “legally sufficient justification” with respect to a challenged policy or procedure. HUD’s new rule largely follows the substance of the August 2019 proposed rule, with some tweaks and one notable exception, by enumerating additional specific defenses available to the defendant. In an effort to provide additional clarity, the final rule also breaks down the defenses into groups based on the specific stage of litigation in which it is available to a defendant — either during the pleading stage or after the pleading stage.
Specifically, at the pleading stage of a claim, defendants may argue that the plaintiffs have failed to plead any one of the five elements above or show that a challenged policy or practice is “reasonable necessary” to comply with a third-party requirement, such as a federal, state, or local law; binding or controlling court, arbitral, administrative order or opinion; or binding or controlling regulatory, administrative or government guidance or requirement. HUD changed the wording of this defense from its August 2019 proposal to clarify that there may be other reasons the defendant may have chosen the course of action or other ways of complying with the restricting law or order, but that the defense applies so long as the challenged action was “reasonably necessary” to comply with the restricting law or order.
In addition, after the pleading stage (i.e., merits stage), defendants may argue that the plaintiffs have failed to meet the burden of proof to establish a discriminatory effect by showing (i) that the plaintiff failed to prove elements two through five above, (ii) that the policy or practice is “reasonably necessary” to comply with a third-party requirement (as described above), or (iii) that the policy or practice is intended to predict an occurrence of an outcome, the prediction represents a valid interest, and the outcome predicted does not or would not have a disparate impact on protected classes compared to similarly situated individuals not part of the protected class. The latter of which can be overcome by the plaintiff demonstrating that an “alternative, less discriminatory policy or practice” would result in the “same outcome . . . without imposing materially greater costs on, or creating other material burdens for the defendant.”
Notably, this predictive analysis defense in the merits stage context is a new addition that replaces another defense contained in the August 2019 proposal. The proposal set forth specific ways that a defendant could rebut a disparate impact challenge against its use of an algorithmic model, including showing the algorithmic model relied on does not use inputs that are substitutes for protected characteristics and is predictive of risk or other valid objective, was created or maintained by a recognized third party, or that a neutral third party has analyzed the model and determined it is a demonstrably and statistically sound algorithm. Ultimately, HUD indicated that the algorithm defense was removed for being “unnecessarily broad” and because the agency anticipates that there will be “further development in the law in the emerging technology area of algorithms, artificial intelligence, machine learning and similar concepts” and thus it would be “premature at this time to directly address algorithms.”
Accordingly, HUD’s final rule eliminates this algorithm-specific defense in favor of a broader defense that potentially applies to any policy or practice that is used for predictive purposes. An example of such a practice that predicts outcomes would be a defendant’s risk analysis used to predict and assess risk. Notably, HUD indicated in the final rule’s preamble that a defendant may show that the predictive analysis is accurate by showing that it is “not overly restrictive on members of a protected class.” For example, if a plaintiff alleges that a lender rejects members of a protected class at higher rates than non-members, because the “logical conclusion” of such a claim would be that members of the protected class who were approved (having been required to meet an unnecessarily restrictive standard) would default at a lower rate than individuals outside the protected class, the defendant may establish that its predictive model is not overly restrictive by showing that its default risk assessment leads to fewer loans being made to members of a protected class but that “members of the protected class who did receive loans actually default more or just as often as similarly situated individuals outside the protected class.”
Policies regarding available remedies and infringement on state’s regulation of insurance
The final rule reiterates the principle from its August 2019 proposal that remedies in disparate impact cases “should be concentrated eliminating or reforming the discriminatory practice so as to eliminate disparities between persons in a particular protected class and other persons.” Rather than restricting administrative law judges as the proposed rule purported to do, HUD limited the remedies provision in the final rule to restricting itself in the types of damages that it will seek where it is the party bringing a discriminatory effects case. Specifically, the Final Rule provides that HUD will seek only equitable remedies, or where pecuniary damage is proved, compensatory damages or restitution. Further, the Final Rule specifies that HUD may seek civil money penalties in disparate impact cases “only where the defendant has previously been adjudged, within the last five years, to have committed unlawful housing discrimination” under the FHA, other than under the disparate impact rule.
Similar to the August 2019 proposal, the Final Rule states that nothing in the disparate impact rule is “intended to invalidate, impair, or supersede any law enacted by any state for the purpose of regulating the business of insurance.”
If you have any questions regarding HUD’s new disparate impact regulation, please contact an Orrick attorney with whom you have worked in the past.