WASHINGTON — The legal environment for fair-lending cases has shifted significantly against banks in the past few months, once again putting the industry on the defensive.

In recent weeks, the financial services industry has suffered two legal setbacks.

First, the Department of Housing and Urban Development formalized its view that even if lenders do not intentionally discriminate, they may be in violation of the Fair Housing Act if their actions have a disparate impact, in a negative way, on certain groups.

Earlier this month, meanwhile, the prospect that the Supreme Court might soon put an end to such disparate-impact cases faded. In an unexpected move, the City of St. Paul, Minn., dropped its appeal to the high court of a lawsuit that had prompted optimism among lenders.

"It was an opportunity to bring clarity to this area, and now an opportunity lost as a result of the city's decision," said Christopher Willis, a lawyer at Ballard Spahr who defends banks in fair lending suits.

The legal setbacks come at a time when the Justice Department is aggressively pursuing fair-lending cases. In December, federal officials announced the largest fair lending settlement in U.S. history — a $335 million agreement with Countrywide Financial Corp., which is now owned by Bank of America.

"We are using every tool in our law enforcement arsenal, including some that were dormant for years," Assistant Attorney General Thomas Perez said when the Countrywide settlement was announced, "to go after institutions of all sizes that discriminated against families solely because of their race or national origin."

The recent developments have buoyed fair-lending advocates, who had been worried that the Supreme Court would make it substantially more difficult to bring such lawsuits.

Shanna Smith, president and chief executive officer of the National Fair Housing Alliance, said that mortgage underwriting criteria related to the age and value of the home, as well as criteria related to the borrower's credit score, can cause disparate harm to minorities and other groups.

"I worry about the lenders, that they've lost that institutional memory of how discrimination can manifest itself in their underwriting policies and practices," Smith said.

Throughout 2010 and 2011, HUD was developing a regulation to codify its view that disparate-impact theory applies in housing discrimination cases, Smith said. It was merely a coincidence, she added, that the proposed regulation was released last November, less than a month after the Supreme Court agreed to take the Minnesota case.

HUD's proposal states that the plaintiff in such lawsuits must first prove that the defendant's practices have a disparate impact on a specific group.

At that point, the defendant must prove that it has a legitimate, non-discriminatory reason for those practices. Then the burden shifts back to the plaintiff to show that there is a better way to achieve those non-discriminatory goals.

The HUD proposal, which is expected to be finalized later this year, is not binding on judges. But there is a line of legal precedent in which courts give deference to the interpretation of the federal agency that is charged with implementing the specific law at issue.

Observers said the HUD rule could eventually help persuade judges not to overturn the existing legal precedents, which currently allow for the use of disparate-impact theory in fair housing cases nationwide.

"If the HUD rule takes effect, that could make it a little more difficult to challenge disparate impact," said Joseph Barloon, a lawyer at Skadden Arps who represents banks in fair lending cases.

Many bank lawyers had been hoping the Supreme Court would overturn that precedent in the Minnesota case. The high court opted to take the case late last year, signaling it may disagree with lower court decisions.

But the City of St. Paul's decision to pull the plug on its appeal means that will not happen anytime soon.

The Minnesota lawsuit was unusual in the sense that private landlords were suing the city, rather than being sued. The landlords argued that the city's housing enforcement activities were having a disparate impact on minorities.

The City of St. Paul had been pushing back against that legal theory — arguing that its efforts were focused on eliminating plagues such as rodent infestations and inoperable smoke detectors.

Bank industry groups sided with the city in briefs filed with the Supreme Court.

In one such brief, the American Bankers Association, the Consumer Bankers Association and other industry groups argued that when Congress wants to ban conduct that has a disparate impact, it does so.

In the case of the Fair Housing Act, "Congress used only disparate-treatment language," the groups argued.

But earlier this month, the city abruptly dropped its appeal, apparently after outside groups pressured it to do so. St. Paul City Attorney Sara Grewing acknowledged in a recent interview with the Pioneer Press that the Justice Department was among the groups that voiced their opinions on the lawsuit.

Even though lenders have lost momentum on the fair-lending front since late 2011, lawyers who represent banks argued that the Supreme Court's decision to hear the Minnesota case is still a positive sign.

"We are still on offense. The government should continue to be concerned about litigating this issue, with it being clear that the Supreme Court has questions about the applicability of the theory," said Andrew Sandler, chairman of BuckleySandler LLP.

"I think over the next two years, the applicability of disparate impact to lending cases will be litigated in many courts throughout the country. And eventually it will return to the Supreme Court, where it will be struck down."

Willis argued that the next logical step for defendants in disparate-impact cases will be to appeal the ruling of a three-judge federal panel to an entire Court of Appeals. That could help pave the way for the issue to get back to the Supreme Court.

"Obviously there's very limited avenues for getting this issue resolved," Willis said.

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