January 22, 2009

New Warranty Regulators:

As the Obama administration gets up and running, new appointees are assuming command of the agencies that affect warranty policy. So far, the Dept. of Transportation, the EPA, and the SEC have new leaders, with announcements expected for the FTC and NHTSA within days. So what's likely to change?

With the inauguration of U.S. President Barack Obama earlier this week, the process of changing over the people and the policies of the federal government has only just begun.

It's not our intent to predict what will happen during the next four years. However, it is clear that the new administration will count the environment, energy, and the economy as among its top priorities. How will the new government's efforts in those areas affect the manufacturers, retailers, repairmen and insurance companies that comprise the warranty industry?

For better or for worse, a change of administrations almost always produces a change in policies and perspectives. And while warranty policy is nowhere near the top of the list of priorities for the new administration, it is highly likely to become a factor in its efforts to reform troubled industry sectors such as banking, insurance, auto manufacturing and homebuilding.

The four federal agencies with the most direct impact on warranties are the U.S. Securities and Exchange Commission (SEC), the National Highway Traffic Safety Administration (NHTSA), the U.S. Environmental Protection Agency (EPA), and the Federal Trade Commission (FTC). All are expected to be run by Obama appointees, and it's highly likely those appointees will implement policies that were opposed by the previous administration. So let's see where we stand and what we face with each.

The SEC's Effect on Warranties

The U.S. Securities and Exchange Commission is an independent federal agency created in 1934 as part of the financial reforms introduced by President Franklin Delano Roosevelt. It is led by five commissioners, of which no more than three at any given time can be from the same political party. One of the five is to be designated as the chairman. Its first Chairman was Joseph P. Kennedy, father of the late President John F. Kennedy.

The SEC is primarily involved in warranties through regulations passed in 2002 after the collapse of Enron that mandate the inclusion of details about off-balance-sheet arrangements and guarantees such as product warranties in all Form 10-K annual reports. Ironically, those regulations weren't written by the SEC (they come from "Interpretation Number 45" as published by the Financial Accounting Standards Board, part of a private non-profit corporation), though the SEC did incorporate them into its code in 2003, in its effort to implement the Sarbanes-Oxley Act of 2002.

In order for a company to say it follows Generally Accepted Accounting Principles (GAAP), it must adhere to all of FASB's rules. And the Securities Exchange Act, as amended in 2003, specifies that companies must comply with FIN 45 disclosure rules. But this hasn't stopped companies such as Xerox Corp., Baxter International, Goodyear Tire & Rubber Co., and several others from completely disregarding those rules. The problem is, FASB has no enforcement mechanism of its own (besides calling something "non-GAAP) and the SEC had enough to do trying to enforce its own rules.

As far as we know, there has never been an enforcement action based upon non-compliance with FIN 45 warranty disclosure rules, although SEC investigations of companies such as Dell Inc. and Delphi Corp. have had an impact upon other aspects of warranty accounting. Will this change in the Obama administration? After recent scandals, we can't see the SEC backing down from disclosure rules that grew out of earlier financial scandals. But will they ever go after a guarantee-issuing company for failing to disclose the financial magnitude of those guarantees? One would think there are more important issues facing the republic.

Unintended Consequences?

On that theme, the response of lawmakers to recent financial scandals remains to be seen, although their attention this time around is more likely to be on the possible regulation of the credit default swaps and other financial speculations that brought down Lehman Brothers, as opposed to the off-balance-sheet arrangements that helped bring down Enron. And the irony is that neither Enron nor Lehman had anything to do with warranties.

In terms of unintended consequences, here's something to consider: credit default swaps, although they insure the buyer against a default by a third party, are not considered to be insurance, even when they're sold by an insurance company. And besides, insurance in the U.S. is regulated at the state level -- not by the federal government, and certainly not at the international level where Lehman played. This in fact was one of the obstacles that slowed down the response of the federal government to the plight of the American International Group Inc.

Inevitably, as Sarbanes-Oxley reforms followed the collapse of Enron and WorldCom, something will follow the collapse of Lehman Brothers and others. Could it be a move to regulate bond insurers at the federal level as is done with commercial banks? That could have an effect on underwriters such as AIG, and on the retailers and extended warranty administrators they support.

And let's not forget the crossover between the sub-prime mortgage lenders who allegedly started this mess and the home warranty providers who had nothing to do with it. Frequently, you're talking about different divisions of the same company. So an effort to more closely regulate one -- perhaps through increased disclosure requirements at the SEC -- may have an effect on the other. There also may be unintended consequences for the ratings agencies that grade the health of financial companies that provide loans, mortgages, insurance, and yes, even extended warranty underwriting services.

New SEC Chairman Confirmed

Following the election of Barack Obama in November, SEC Chairman Christopher Cox signaled his intention to step down from his political appointment on Inauguration Day. A staunch conservative and a former Republican member of the House of Representatives (representing Orange County, California), Cox also previously served as a junior member of the White House legal team of Republican President Ronald Reagan.

In the new administration, therefore, Cox would probably not have fit in so well, had he decided to stay on. Instead, the SEC will be led by Obama appointee Mary L. Schapiro, who was confirmed by the U.S. Senate late this evening. This marks a return of sorts for Schapiro, who served as an SEC commissioner from 1988 to 1994, having been appointed by President Ronald Reagan at the tail end of his term. [Despite how old that makes her sound, Forbes Magazine reports her to be only 52 years of age.]

Schapiro had been the chief executive of the Financial Industry Regulatory Authority. FINRA was formed in July 2007 through the merger of the self-regulatory arms of the National Association of Securities Dealers and the New York Stock Exchange. She's also a former chairperson of another government agency called the Commodity Futures Trading Commission (CFTC), which former Treasury Secretary Henry Paulson had said he wanted to merge with the SEC. If that merger plan is still on track, observers note, Schapiro may be the ideal appointee, because she has experience at both agencies and also has experience merging regulatory bodies in the private sector.

The SEC she joins this second time around, however, has come under withering criticism for missing virtually every massive swindle of the last decade -- everything from Enron to Bernie Madoff, with the dot-com and housing bubbles bursting somewhere in between. It's not apparent what the SEC could have done differently, except perhaps to have projected an image of engagement in the markets it was supposed to regulate. In politics, appearance is reality.

Laissez-Faire Regulators

However, perhaps the SEC functioned exactly as was intended? Perhaps they wanted the least amount of regulatory oversight possible, essentially allowing the market to regulate itself? In fact, President George W. Bush left the office of SEC chairman vacant for the first six-and-a-half months of his first term in 2001, and left it vacant again for a month in 2007. Also, after former SEC Commissioners Roel C. Campos left in September 2007 and Annette L. Nazareth left in January 2008, neither was replaced until the summer of 2008. To help put such a benignly neglectful attitude into perspective, imagine the outcry if President Obama left the SEC chairmanship vacant until August 2009.

As the books were closed on the Bush administration earlier this week, the five SEC commissioners were Chairman Cox, Kathleen L. Casey, Troy A. Paredes, Luis A. Aguilar and Elisse B. Walter. The first three were Republican appointees while the last two were Democratic. All five, however, were appointed by President Bush, and each was appointed to a five-year term. Chairperson Schapiro, we note, is officially an Independent, though she was appointed first by a Republican and now by a Democratic President.

Cox was of course a Republican. Casey, also a Republican, is midway through a five-year term that ends on June 5, 2011. The other three are serving terms that began in the summer of 2008. Unless one of them steps down, therefore, there may not be another vacancy on the SEC board until after President Obama's current term ends in 2013. In other words, don't look for a sweeping changing of the guards unless the President decides there must be a sweeping changing of the guards, and forces some Bush appointees out.

The TREAD Act and Warranties

The National Highway Traffic Safety Administration, as part of the U.S. Department of Transportation, has a very noticeable effect on automotive manufacturing through its regulations and safety recalls. And also as an example of how regulation frequently follows scandal (the Ford Explorer and Firestone tire failures leading to the TREAD Act) NHTSA has since 2002 also had a major effect on automotive product warranties.

The U.S. Department of Transportation was created by Congress in 1966, along with agencies of various names that were tasked with looking after different facets of traffic safety. The agency now called NHTSA was formally established in 1970.

The position of the Secretary of Transportation is a Cabinet-level appointment to be made by the President and confirmed by the U.S. Senate. The term of former U.S. Transportation Secretary Mary E. Peters expired with the end of the Bush administration on Jan. 20. She has been replaced by Ray LaHood, a Republican congressman from Illinois who was nominated by President Obama and was confirmed by the U.S. Senate late this evening.

NHTSA Appointments

Nicole R. Nason had been NHTSA Administrator from May 2006 until September 2008. Since that time, her chief of staff David Kelly had been filling in as the acting administrator and Jim Ports was the deputy administrator of NHTSA. But as political appointees, both their terms ended on Inauguration Day. Therefore, during this transitional period, Ronald Medford, who as a top career employee has been NHTSA's senior associate administrator of vehicle safety, will serve as the acting deputy administrator of NHTSA until new political appointees are named by the Obama administration.

Nason's two years of service were marked not so much for her agency's achievements as for its bizarre press relations policies. As described by a New York Times reporter, her policy mandated that only top political appointees could be quoted by name, and those lower down the org chart could provide only background information to the press. This had the practical effect of removing the comments and opinions of most of NHTSA's top safety experts from the world's newspapers, because most reporters declined to ask political appointees questions that required detailed technical answers.

Throughout its history, NHTSA has battled with the automakers over the economic cost of new regulations. President Bush's first appointment as NHTSA Administrator was Dr. Jeffrey W. Runge, who left NHTSA in 2005 to take a job as chief medical officer at the newly-created Department of Homeland Security. During his tenure at NHTSA, the early warning reporting requirements of the TREAD Act were implemented, causing automotive manufacturers in late 2003 to begin uploading quarterly filings about accidents, defects, injuries, and warranty claims. NHTSA (and the manufacturers themselves) would then examine the data in spreadsheet form, looking for patterns or anomalies that suggested a correctable defect.

Massive recalls inevitably followed, but so did lower warranty expenses, as defects were caught and corrected earlier than before. Thanks in part to the early warning reporting system, Recalls peaked at 30.8 million vehicles in 2004, in 600 separate recall actions. However, since then the system seems to have proved itself, allowing patterns to be caught sooner, based on just a few dozen incidents, and allowing the inevitable recalls to be restricted to a much smaller group of vehicles, based on limiting factors such as manufacturing date, climate, or the optional equipment installed on the vehicle.

Although the number of vehicles affected by recalls fell precipitously to 10.2 million in 2008 (the lowest annual total since 1994), the number of recall actions actually increased to 642. A recent article in the Detroit News attributed this trend to the early warning reporting system, which allowed regulators and manufacturers to take more specific and earlier action than before.

Not addressed was the opinion that by forcing the automakers to create and file the reports, NHTSA was also enabling them to do their own early warning research, possibly finding patterns and anomalies before the government did. Would the automakers have moved towards sophisticated warranty analytics if not for NHTSA? We will never know.

Confidentiality Expected?

On balance, we can't imagine a scenario where NHTSA dismantles its early warning reporting system. In fact, it seems to be one of those cases where the government really is helping private companies to cut costs, reduce harm, and make better products. As recently as last month, a major automaker said its early analysis of warranty claims data helped it to limit the scope of a recall.

However, we can foresee a change in attitude about keeping all the TREAD Act data secret, and can imagine a day when it becomes available online in a heavily redacted or summary-only format. And unlike the SEC data, which is in dollars only and reflects the warranty spending of entire companies, the NHTSA data will be in units sold and may have additional breakdowns by make, model, and perhaps even by trim. This could be just the kind of hard data that would confirm or refute the kinds of opinions that underpin most of the best-known quality ratings that the automakers use so heavily in their marketing.

If the public statements of top American auto executives are to be believed, then their warranty expenses and/or incident rates have all fallen dramatically in recent years. But because Chrysler LLC is privately-held, and because many of the importers don't have to file any financial reports with the SEC, we cannot use public data to compare the before and after for any companies besides Ford and General Motors. So ironically, the confidentiality of NHTSA data adversely affects Ford and GM by making their data the only complete set available for analysis.

Furthermore, we suspect that imported brands such as Mercedes-Benz, Nissan and Volkswagen have warranty costs towards the upper end of the scale, despite their reputations for flawless products. And we suspect the American-made output of transplants such as Toyota, Honda, and Hyundai is towards the lower end of the warranty cost scale, with the Detroit Three somewhere in the middle. But without hard data, we can't prove these opinions.

Then again, the NHTSA database also includes personal details on those who have been injured or killed in road accidents. That information should not be released for privacy reasons. And the data on warranty claims would include VIN numbers that could help the "your warranty is about to expire" lowlifes make their pitches even more specific. In addition, the information was collected from manufacturers with promises of confidentiality. Can a new administration now break those promises retroactively?

Others who have held the Administrator's job at NHTSA include John W. Snow (later Secretary of the Treasury), Joan Claybrook (the soon-to-retire president of the consumer advocacy group Public Citizen), and Marion Blakey (who later became the FAA Administrator). Ironically, Claybrook and her group have been among the most vocal critics of NHTSA's decision to keep confidential all of the warranty data it receives from manufacturers.

Other Regulatory Effects

Also having a regulatory effect on safety and equipment design, and therefore on manufacturing and warranty policies, are several of the other ten operating administrations within the DOT, including the Federal Aviation Administration, the Federal Highway Administration, the Federal Motor Carrier Safety Administration, the Federal Railroad Administration, the Federal Transit Administration, the Maritime Administration, and the Pipeline and Hazardous Materials Safety Administration. All will now need new administrators and political staff.

Perhaps after having seen the effectiveness of the TREAD Act and the NHTSA early warning reporting system, other regulators from other industries are now considering similar rulemaking efforts. For instance, the U.S. Food and Drug Administration has proposed the Sentinel Initiative, which would give the agency an early warning of product defects and safety problems by allowing it to probe and monitor the manufacturing process in the medical device field. The resulting Sentinel System would allow the FDA to query existing data sources such as electronic health record systems and medical claims databases for information about the performance and reliability of medical equipment.

NHTSA also administers the Corporate Average Fuel Economy (CAFE) standards, which set standards for miles per gallon for both passenger cars and light trucks, based on unit sales. This was meant to drive buyers towards smaller and more fuel-efficient cars. But paradoxically, some say the classification of SUVs as light trucks, which for the purposes of CAFE took them out of the "passenger car" category, helped the automakers sell more of them without running up against CAFE limits.

Plans to revise the CAFE standards were abandoned late in the Bush era, effectively postponing action until Obama's appointees take over. While it's highly likely that energy efficiency and alternatives to gasoline will be the priorities for the future, the reality is that SUVs were until just a few months ago the sweet spot in the product line. Given the cost of changing that product line, one can only imagine how the CAFE revisions might clash with efforts by other agencies to keep the automakers in business.

Environmental Warranties

As for an effect on warranty for this clean energy focus, one need look no further than current hybrid offerings in the auto industry and the solar offerings of the homebuilding industry, which are usually backed by longer-than-usual warranties. The hybrid batteries are backed for at least eight years and some of the rooftop solar systems carry 25-year warranties.

This is done primarily to overcome the suspicions of buyers that they'll have to make costly repairs in the future, and secondarily to meet the environmental warranty requirements of the various state and federal regulators. For instance, it's considered good policy to keep the repair of emission control systems free through long warranties, to encourage car owners to get them repaired. So as the regulators look for ways to encourage changes in behavior, it's likely longer warranties will become part of the appeal.

The U.S. Environmental Protection Agency opened for business in 1970 as an independent agency of the federal government. As with the SEC, the EPA is an independent agency whose head reports to the President but is not a formal member of the President's 15-person Cabinet.

The outgoing Bush-appointed EPA Administrator is Stephen L. Johnson and the incoming appointee is Lisa Perez Jackson. This is Jackson's second shift at the EPA, having served previously under President Clinton's EPA Administrator, Carol M. Browner. Jackson spent the Bush years working at the state level for the New Jersey Department of Environmental Protection and as chief of staff for New Jersey Governor Jon Corzine. Along with LaHood, Schapiro, and several other appointees, Jackson was confirmed by the Senate late this evening.

Browner, by the way, is expected to take on a new role as Obama's top environmental and energy advisor. As a White House-based assistant to the President, she would have wide-ranging control over environmental policy. Before she became EPA Administrator in 1993, Browner was a legislative director for then-Senator Al Gore. She also ran the transition team when he was elected Vice President. After leaving office in 2001, she joined several environmental groups, including the Audubon Society and the Alliance for Climate Protection, the latter of which is funded in part by the proceeds from Gore's documentary, An Inconvenient Truth.

The EPA and Warranties

The EPA will have a somewhat peripheral effect on warranty, primarily through its regulation of automotive engine emissions, but also through its rules concerning energy usage levels by appliances, and recycling efforts for discarded electronics and computers. The Obama administration is likely to give a high priority to environmental issues such as global warming, perhaps by going as far as regulating carbon dioxide as a pollutant under the Clean Air Act. Such a move would give the EPA a much greater say in the design of numerous types of CO2-emitting equipment -- not only passenger cars and trucks, but also power plants, turbines, aircraft, lawn mowers, and many types of construction, mining and farm equipment.

As an example, take a look at how the EPA managed the reduction of emissions by diesel truck engines. The Heavy-Duty Highway Diesel rule, also known as the 2007 Highway Rule, mandated a 97% reduction in the sulfur content of highway diesel fuel, from its old maximum level of 500 parts per million to 15 ppm. Another rule, called the 2.5 gram NMHC+NOx emission standard, mandated the reduction of hydrocarbons and nitrogen oxides by heavy-duty truck engines.

With the latter standard, the EPA set a late 2002 deadline which engine makers such as Caterpillar and Cummins were forced to meet. Customers, worried about the running cost and reliability of the new designs, bought up all of the previous year's models before the deadline. After the deadline passed, sales fell and it took almost a year for them to get back to normal. Engine manufacturers, in their attempts to increase sales, frequently used better warranty coverage (e.g. guaranteeing replacement trucks if lengthy repairs were necessary) as a deal sweetener.

In the Obama administration, if biofuel-burning combustion engines become preferred to those burning diesel or gasoline, more extensive redesigns may be required at the passenger car and light truck level. Already, there have been cases where alternative fuels have caused parts to corrode and leaks to develop, causing expensive recalls. And we're not talking about alchemists that use the oil from French fries. Toyota's Lexus unit just recently recalled 214,500 vehicles that may develop leaks from the use of even the 10% ethanol blend that the vehicle's warranty allows.

At some point, manufacturers that now void their engine warranties if non-standard biofuels are used may be told to modify those terms and conditions -- or else. The same goes for those who now void their warranties if their hybrid vehicles are modified for plug-in recharging or are supplemented with additional batteries. Fortunately, there may be some money in the forthcoming economic stimulus bill to fund the migration to alternative fuels and new battery charging technologies.

Energy Star

As another example of what may lie ahead, take a look at the Energy Star program. The U.S. Department of Energy assigns an efficiency rating known as a "seasonal energy efficiency ratio," or SEER, to each central air conditioning unit sold in the U.S.. In addition, in 1992 the EPA and the Department of Energy jointly created the Energy Star program, which uses its logo to help consumers find energy-efficient appliances and electronics while they're shopping. In some cases, air conditioning units with higher SEER ratings and Energy Star designations also feature longer warranties.

For most types of appliances, the EPA's rules merely state that the warranty issued for an Energy Star model cannot be shorter than whatever is prevalent with non-Energy Star models. But in a few instances, the rules actually specify the minimum warranty durations. For instance, the motor in an Energy Star ceiling fan must be warranted for at least 30 years, and any included lighting fixtures must be warranted for at least two years, but the warranties on other components can be as short as one year. Meanwhile, the warranty on a fluorescent bulb must run for at least two years in order to qualify for an Energy Star designation.

This warranty-mandating trend has yet to spread very far into other types of appliances and electronics, however. And it will be some time before President Obama's nominees get down to the nitty gritty level of what to do about programs such as Energy Star. But one can see how the appeal of lower running costs and longer warranties could be used by manufacturers and retailers to steer customers towards certain models. And one can see how the government might want to encourage that as well.

Then again, manufacturers of products such as furnaces, heat exchangers and water heaters actually spoke out vigorously against minimum warranty durations when it came time to set rules for their Energy Star designations. Some said warranty policies should be determined by competition in the free market, and should not be dictated by regulation or standards. Longer warranties would add cost, they said, while doing little to boost consumer confidence. Others said that since there was no enforcement mechanism within Energy Star to make sure manufacturers honored warranty claims (and no recourse for customers whose obligors went out of business), mandates calling for longer warranties would end up as meaningless gestures.

Another warranty-related environmental issue will arise once the EPA and/or other agencies decide what to do about the recycling of old appliances, electronics, and computers, some of which contain hazardous substances. Already, numerous European countries and a few U.S. states have begun collecting end-of-life recycling fees from customers at the time of purchase, in an effort to help finance their ultimate disposal.

This may have a direct impact on warranty professionals. While warranty policies are traditionally focused on the beginning of ownership, the reverse logistics infrastructures used for warranty work are increasingly being employed to make this recycling actually happen. If the collection of recycling fees and the recycling of discarded units ever becomes a federal mandate, look for the warranty departments of the major retailers, manufacturers, and service contract administrators to be given the task to implement it.

The FTC and Warranty Laws

Finally, we can't help but wonder what will happen to the Federal Trade Commission, the enforcers of the primary federal warranty law: the Magnuson-Moss Warranty Act of 1975. That law doesn't actually require warranties, but it does mandate what they must include and how they must be disclosed if they are offered. This is different from the situation in Europe, where warranties on most consumer products are required, and minimum durations are specified.

The FTC, like the SEC and EPA, is an independent agency of the federal government. And as with the SEC, the president gets to nominate the five FTC Commissioners, and to designate one of them as the FTC chairman. However, they each serve for seven-year terms instead of the SEC's five. And the FTC reports to Congress, not to the president. Also, while the EPA traces its roots back to the pollution-plagued 1970s and the SEC came out of the Great Depression, the FTC has been around since 1914, when trust-busting and consumer protection became federal priorities.

Current FTC Commissioners include Jon Leibowitz, Pamela Jones Harbour, J. Thomas Rosch, and Chairman William E. Kovacic. There is also one vacancy. As with the SEC, no more than three of the five may be from the same political party. Rosch and Kovacic are Republicans. Leibowitz is a Democrat, and Harbour is an Independent.

President Obama has yet to make his choices known as of this evening. He has at least one vacancy to fill, and possibly two if -- as is tradition -- the Chairman steps down to make way for someone of the President's own political party. However, there's nothing preventing President Obama from appointing a member of any party to the FTC. Or, as is the current hot rumor, he could choose to elevate an existing commissioner such as Leibowitz to the chairmanship, in which case he may have two commissioner positions to fill.

The FTC publishes helpful documents such as "A Businessperson's Guide to Federal Warranty Law." But on the actual subject of warranties, enforcement has been slight in recent years. Last year the FTC revamped its "do not call" rules to stop the plague of "your warranty is about to expire" telemarketing, and way back in 2002 the commission reinforced that its warranty disclosure rules definitely do apply to online merchants. In between, there hasn't been a lot of warranty news coming out of the FTC.

Let's be hopeful and optimistic and say that the FTC has virtually unlimited room to grow into its role as the government's top warranty enforcer. If it could actually end the expired warranty telemarketing calls (as opposed to just outlawing them), the nation would be grateful. And if it could bring some clarity to when online shoppers are buying gray market goods with no warranty and when they are shopping at an online merchant authorized by the manufacturer, that would be a welcome development also.

Bottom line, the new President has a lot of appointing to do in the near future, and then has to make some choices about which policies to enhance and strengthen, and which to reverse. Federal warranty policy comes out of not only the SEC and NHTSA, but also the EPA and FTC. And just as warranty processes are interconnected with numerous other business processes and departments, so too is the process of its regulation. Environmental and economic policies that may at first seem to have nothing to do with warranty can end up affecting it in profound ways.

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