WASHINGTON—A federal appeals court on Tuesday issued an across-the-board rejection of the Consumer Financial Protection Bureau, ruling its structure unconstitutional and setting aside a closely watched enforcement action against a mortgage lender.
The decision by a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit was a considerable blow to the agency created five years ago by the post-financial crisis Dodd-Frank law. A central part of the ruling said the consumer-finance watchdog violated the Constitution's separation of powers because its director isn't sufficiently answerable to the president.
The court rejected the idea of shutting down the CFPB and instead said the remedy is to give the president the power to remove the bureau's director at will and to supervise and direct his actions.
That change could make the CFPB a more political agency than it is now, because the White House would be able to exert more control over its direction. For example, the ruling would give the next president a freer hand to remove Director Richard Cordray before his term expires in 2018.
In addition to rejecting the structure of the CFPB, the appeals court also said the agency made considerable legal errors in its enforcement action against mortgage lender PHH Corp. Among them, the CFPB adopted a new and flawed interpretation of a real-estate industry law and wrongly applied that interpretation retroactively to business conduct that took place before the switch, the appeals court said.
The CFPB has the option of asking to D.C. Circuit to rehear the case with a full roster of judges participating. The case ultimately could be appealed to the Supreme Court.
The ruling is the latest setback for the 2010 Dodd-Frank law, which created the CFPB as part of a package of regulatory changes in response to the 2008 financial crisis. Long criticized by Republicans and subject to an array of legal challenges, the law was passed when Democrats controlled Congress and signed by President Barack Obama. Earlier this year, for instance, MetLife Inc. won a major legal victory against the Financial Stability Oversight Council, also created by Dodd-Frank, to shed the government's designation of it as a "systemically important financial institution."
The CFPB is headed by a single director who, until Tuesday's ruling, could be removed by the president only for cause.
The decision, written by Judge Brett Kavanaugh, said that structure was a "gross departure" from the traditional manner of setting up independent agencies, which have multiple commissioners or board members who served as a check on one another.
Congress gave the CFPB director "more unilateral authority than any other officer in any of the three branches of the U.S. government, other than the president," wrote Judge Kavanaugh, a George W. Bush appointee. He said the problem of checks and balances was particularly acute because the CFPB "possesses enormous power over American business, American consumers and the overall U.S. economy."
The appeals court allowed the CFPB to continue operating as an agency, but ordered a restructuring of how it operates in the executive branch. "The CFPB therefore will continue to operate and to perform its many duties, but will do so as an executive agency akin to other executive agencies headed by a single person, such as the Department of Justice and the Department of the Treasury," the court said.
"The bureau is considering options for seeking further review of the court's decision," a CFPB spokeswoman said, adding the ruling "will not dampen our efforts or affect our focus on the mission of the agency."
Theodore Olson, a lawyer representing PHH, said the company was "very gratified that the D.C. circuit has unequivocally and firmly vindicated the conduct of PHH." He added the ruling made it clear the CFPB "was created by Congress in a way that violated fundamental separation of powers and is unconstitutional as it has existed prior to this opinion."
At issue was a case the CFPB initiated in 2014 against PHH, a New Jersey-based mortgage lender. Eventually the bureau ordered the firm to shed $ 109 million for allegedly violating the Real Estate Settlement Procedures Act by accepting kickbacks from mortgage insurers.
Most CFPB enforcement cases so far have produced settlements with companies. Because of the lack of litigated cases, the PHH dispute was considered one of the first big tests of the agency's authority.
The bureau alleged PHH engaged in an unlawful kickback scheme that boosted costs for home buyers who needed mortgage insurance. The CFPB also said PHH referred borrowers to insurers with whom it had financial relationships, which weren't necessarily the insurers with the lowest rates.
The case first went to an administrative judge who found PHH violated the law but ordered a relatively small sanction: a $ 6.4 million disgorgement of ill-gotten financial gains. CFPB Director Richard Cordray took a much stiffer view of the law and of the extent of PHH's alleged violations, imposing the considerably larger disgorgement penalty of $ 109 million.
Mr. Cordray's interpretation of the real-estate law differed substantially from that of the Department of Housing and Urban Development, which administered the law before the CFPB came into existence.
The appeals court ruling Tuesday said Mr. Cordray's interpretation was incorrect. And it said the CFPB "violated bedrock due process principles" by applying its new interpretation retroactively.
Another key issue raised in the PHH case was the question of whether a statute of limitations applied to the CFPB's enforcement effort. The CFPB has taken the position that Congress didn't set a time limit for bringing administrative proceedings. The court, however, said a three-year limit applies to enforcement of the alleged kickback violations, a holding that prevents the CFPB from attempting to punish alleged conduct that took place before then.
The appeals court said the CFPB's position was absurd and would have allowed the bureau unlimited time to bring administrative cases under all 19 of the consumer-protection laws the agency enforces.
"The statute of limitations issue will significantly undermine the bureau's practice, which is to look back and seek restitution for many years, often before the bureau even existed," said Andrew Sandler of Buckley Sandler LLP. He added that the court's ruling against the CFPB on retroactive enforcement of new legal interpretations will "significantly limit its ability to seek damages for past periods of time in certain circumstances."
An array of banking and business groups filed amicus briefs supporting PHH in the case, including the American Financial Services Association, the U.S. Chamber of Commerce and the National Association of Home Builders.
The D.C. Circuit panel, comprised of three judges, was unanimous in faulting how the CFPB brought an enforcement action against PHH. Judge Karen Henderson dissented on the constitutional holding, saying the court didn't need to address that question to resolve the case. All three judges were appointed by Republican presidents.
—Mark H. Anderson contributed to this article.
Write to Brent Kendall at brent.kendall@wsj.com and Yuka Hayashi at yuka.hayashi@wsj.com
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