Sheppard Mullin Financial Institutions Law Blog

Lender's Representation That Borrower "Qualified" For Loan Not A Representation Borrower Could "Afford" A Loan

Question: Is a lender's representation to a borrower that the borrower can "qualify" for a mortgage loan a representation that the borrower can also "afford" the loan?

Answer: No, according to the First District Court of Appeal in Perlas v. GMAC Mortgage, LLC (No. A125212), decided August 11, 2010.

]]> In this case, the plaintiff borrowers obtained a refinance loan from GMAC. According to their complaint, plaintiffs signed an Application stating their "total income" was substantially greater than the actual information they provided to GMAC. (Plaintiffs claimed they signed the Application without being given an opportunity to review it.) Their actual income was not enough for them to make the required Loan payments.

Six months later, GMAC's agent recorded a notice of default. The borrowers filed suit alleging various claims. In response to the defendants' demurrer, they argued that through its knowingly false representation that the borrowers were "qualified" for the Loan, GMAC was in effect representing that they could "afford" the Loan and make the required payments. The trial court sustained the demurrer.

The First District affirmed, noting that nowhere did plaintiffs allege GMAC had expressly represented to them they had the ability to make the loan payments specified in the loan documents. In effect, the borrowers were arguing "that they were entitled to rely upon GMAC's determination that they qualified for the loans in order to decide if they could afford the loans." The Court of Appeal rejected this argument, citing previous cases holding that there is no fiduciary relationship between a borrower and lender, that a lender owes no duty of care to a borrower in approving a loan, and that a "lender's efforts to determine the creditworthiness and ability to repay by a borrower are for the lender's protection, not the borrower's."

Authored by:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com

"Schumer Box" Disclosure Not "Clear and Conspicuous" As a Matter of Law

Question: Is a Schumer box disclosure describing an APR as "fixed," linked with an asterisk to a paragraph printed just below the Schumer box stating the APR could be increased under three conditions, and also coupled with language, further down the same page, providing the customer would be bound by the terms of the bank's customer agreement (which permitted the bank to change rates at any time) "clear and conspicuous" under the Truth in Lending Act?

Answer: No, as a matter of law, according to a divided Ninth Circuit Court of Appeals in Rubio v. Capital One Bank (No. 08-56544), decided July 21, 2010.

]]> In this case, Capital One sent plaintiff Raquel Rubio a credit card solicitation with a "Schumer Box" a table required by federal law, describing the credit card's APR as a "fixed rate of 6.99%." Next to the box was an asterisk linked to a paragraph just below the Schumer box stating the APR could increase in three specific circumstances. Further down the same page, there was a heading that read "Terms of Offer." Under that heading, printed in 8 point type, was language reciting that the customer agreed to be bound by the terms and conditions of Capital One's Customer Agreement. And, in the Agreement, Capital One reserved the right to "amend or change any part of your Agreement, including periodic rates and other charges . . . at any time."

The trial court granted Capital One's motion to dismiss Rubio's TILA (and also her claim under California's Unfair Competition Law). The Ninth Circuit reversed. Writing for the majority of a three-judge panel, Judge Betty Fletcher held that as a matter of law, these disclosures did not constitute a "clear and conspicuous disclosure" of Capital One's APR as required by TILA (see 15 U.S.C. § 1632(a).) Taking the unusual step of considering evidence outside the pleadings on a motion to dismiss, the majority relied heavily on a study commissioned by the Federal Reserve finding that "participants frequently assume that a rate that is labeled 'fixed' cannot be changed for any reason."

The majority also noted that in late January 2009, the board promulgated revisions to regulation Z that the term "fixed" may not be used "unless the creditor also specifies a time period that the rate will be fixed and the rate will not increase during that period . . . ." As a result, the majority was persuaded that because "fixed" can reasonably be interpreted to mean "unchangeable" Capital One's disclosure was not "clear and conspicuous" as a matter of law. It therefore reversed the district court's dismissal of Rubio's TILA claim.

In a partial dissent, Judge Susan Graber agreed the district court should not have dismissed Rubio's TILA claim. Instead of deciding the "clear and conspicuous" disclosure issue as a matter of law, however, Judge Graber would have remanded this issue to the district court for resolution as a matter of fact, not law, after full presentation of evidence. Judge Graber noted that there "seems to be a circuit split regarding the question whether the clarity of a disclosure is a question of law or fact." The Seventh Circuit "holds that this is a question of law." The Third Circuit "appears to treat the clarity of a disclosure as a question of fact." According to Judge Graber, the majority's "reliance on evidence outside the pleadings underscores the appropriateness of fact-finding in a case such as this."

Authored by:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com

New Los Angeles Ordinance Requires Banks And Lenders To Repair Vacant Residential Property

In another blow to residential lenders, the city of Los Angeles has passed an ordinance that will require the person that owns or is in control of certain residential real property to maintain the property in a safe and sanitary condition and in good repair. While one might logically expect that this ordinance would only apply to financial institutions once they have foreclosed upon the property or taken it back via a deed in lieu of foreclosure, the ordinance appears to go farther than that, requiring the financial institution to take responsibility for the condition of the property once a notice of default has been filed.

]]> Effective July 8, the new ordinance requires lenders to register all residential real properties with the city (i) that have been through foreclosure and are now owned by the lender; (ii) that are currently "Properties in Foreclosure," which is defined to mean any property upon which a notice of default has been issued, or (iii) for which a notice of default is issued in the future. An annual registration fee of $155.00 must be paid to the Los Angeles Housing Department at the time of registration. As an alternative, the information required for registration of the property can be provided to the Mortgage Electronic Registration System (MERS), in which case no registration fee will be payable. It is anticipated that this registry will enable inspectors to easily identify owners (or lenders, if foreclosure has yet to occur) if a constituent calls to complain about the condition of a property.

Once a residential real property becomes a Property in Foreclosure, the beneficiary or trustee under the deed of trust on the property is required to inspect it, and reinspect it monthly until the default is remedied. Inspections are required to continue following foreclosure if title to the property is transferred to the beneficiary. The beneficiary/trustee is then required to maintain the property in a safe and sanitary condition and in good repair, in accordance with the requirements set forth in Section 91.8901 of the Los Angeles Municipal Code (although query how the beneficiary/trustee may legally do this if the borrower still owns the property, or how the beneficiary/trustee is supposed to obtain access to the property if the borrower continues to reside in the property pre-foreclosure).

If the property is found to be vacant (which is also defined to include occupied by an unauthorized person), even prior to completion of foreclosure, the beneficiary/trustee is then required to clean, fence and barricade the property. Failure to do so is a strict liability offense. If the property is determined to have been vacant for 30 consecutive calendar days, the owner or person in charge or control of the vacant structure may be liable for an administrative penalty of $1000 per structure per day, not to exceed $100,000 per property per calendar year.

Authored By:

Sherwin F. Root
(213) 617-5465
SRoot@sheppardmullin.com

Ohio Federal District Court Rules That HUD's Sham Joint Venture Guidelines Are Unconstitutional

In a decision that was handed down on June 30, 2010, a United States District Court for the Northern District of Ohio has ruled that HUD's sham joint venture guidelines, as contained in HUD's RESPA Statement of Policy 1996-2 (the "Policy Statement"), are unconstitutionally vague, and has granted the defendants summary judgment against claims by the plaintiffs that certain affiliated title agencies violated RESPA. Carter v. Wells-Bowen Realty, Inc., 2010 WL 1607266.

]]> The plaintiffs were two individuals who, in connection with obtaining mortgage loans, purchased title insurance services from Welles Bowen Title Agency ("WB Title") and Integrity Title Agency ("Integrity Title") . WB Title was formed as an affiliated business arrangement by defendants Chicago Title and Welles Bowen Realty. Integrity Title was formed as an affiliated business arrangement by defendants Chicago Title and the Danberry Co., which, like Welles Bowen Realty, is a real estate broker. Chicago Title owned 50.1% of WB Title and Integrity Title, and Welles Bowen Realty and Danberry Co. owned the other 49.9% of WB Title and Integrity Title respectively. The plaintiffs alleged that WB Title and Integrity Title performed limited services, and that they were sham companies that were formed to be conduits for kickbacks from Chicago Title to Welles Bowen Realty and Danberry Co. in exchange for referrals. Plaintiffs did not allege that they received subpar title insurance services or that they were overcharged for the services they received, although the court acknowledged (as the Sixth Circuit had held in an earlier decision in this case) that overcharges were not necessary to prove a RESPA violation.

The defendants moved for summary judgment, arguing that WB Title and Integrity Title performed real title services, and had also complied with all of the requirements for affiliated business arrangements set forth in RESPA and Regulation X, in that the joint venture companies had provided timely affiliated business arrangement disclosures, had not required that the plaintiffs use any particular title agency, and that the only thing of value that the owners of WB Title and Integrity Title had received was a return on their ownership interests in WB Title and Integrity Title. The defendants also argued that the guidelines set forth in the Policy Statement were unconstitutionally vague and therefore unenforceable. The court agreed with the defendants.

The court first pointed out that, since RESPA violations can result in criminal penalties, the claim of vagueness requires fairly strict review, even though only civil penalties were sought by the plaintiffs. The court then analyzed the Policy Statement guidelines. including the ten factor test employed by HUD in the Policy Statement, and found that the guidelines' use of terms such as "sufficient capital," "reasonable compensation" and "performance of substantial services" required inherently subjective evaluations without any guidance as to how to determine what levels of capital were sufficient, what compensation was reasonable, and what level of service performance was substantial. The court also found that the balancing of the ten factors in the Policy Statement guidelines compounds the vagueness because there is no description in the Policy Statement as to how the factors are to be balanced.

It is likely that an appeal will be made to the Sixth Circuit on this issue. HUD will no doubt be filing a brief in support of its Policy Statement. One potential argument by HUD might be that it never intended for the joint venture guidelines to be privately or judicially enforced, and that it was simply attempting to inform the industry and the public what factors it would consider in evaluating whether particular affiliated business arrangements were sham arrangements. We will be monitoring this case closely, but in the meantime, we urge our clients with affiliated business arrangements to continue to attempt to comply with the Policy Statement to the greatest extent possible.

Authored By:

Sherwin F. Root
(213) 617-5465
SRoot@sheppardmullin.com

The California Court Of Appeal Narrowly Interprets The Perata Mortgage Relief Act

On June 4, 2010, the California Court of Appeal issued its first important decision on the scope of California's Perata Mortgage Relief Act, passed into law in 2008 and codified at California Civil Code Sections 2923.5 and 2923.6. See Mabry v. Superior Court (Case No. G042911, June 4, 2010) ---Cal.App.4th---, 2010 WL 2180530.

]]> Though the Court held that plaintiffs have a private right of action under the PMRA, it also held that the PMRA does not require lenders to modify loans, but only to contact (or attempt to contact) borrowers about possible options to potentially avoid foreclosure. The Court's other holdings also limit the impact of the PMRA, eviscerating the claims of many plaintiffs seeking to halt or unwind foreclosure sales in the wake of the mortgage crises.

In 2006, Plaintiffs Terry and Michael Mabry refinanced the loan on their home, borrowing about $700,000. In September of 2008, Plaintiffs stopped making their payments. In June of 2009, the lender recorded a notice of default. In October of 2009, Plaintiffs filed a class action complaint claiming that the lender failed to contact them to explore loan modification or other options prior to foreclosure. The lender disputed Plaintiff's contention. The trial court initially granted a temporary restraining order, then later vacated the order, holding that the PMRA (1) does not bestow any private right of action and (2) is preempted by federal law. Plaintiffs petitioned the appellate court for a writ of mandate.

The Court of Appeal disagreed with the rulings of the trial court, and held that the PMRA may be enforced by a private right of action. The Court noted that Section 2923.5 is silent as to a private right of action, but that it requires lenders to contact borrowers prior to foreclosure to explore possible options to potentially avoid foreclosure. The Court held that, to have any meaning, a private right of action must be implied, and that exclusive enforcement by the Attorney General's office would not be sufficient. Id. at *9-*11.

The Court also held that federal banking law does not preempt the PMRA, but only because of the limited reach of the state law. "There is nothing in section 2923.5 that requires the lender to rewrite or modify the loan." Id. at *1. We "are able to come to our conclusion that section 2923.5 is not preempted by federal banking regulations because it is . . . very narrow. As mentioned above, there is no right, for example, under the statute, to a loan modification." Id. at *12. As for Section 2923.6, it "does not operate substantively. Section 2923.6 merely expresses the hope that lenders will offer loan modifications on certain terms." Id. at *6 (emphasis in original). To have "required loan modifications would have run afoul of federal law." Id. (emphasis in original).

These holdings are significant to the current wave of mortgage litigation for two reasons. First, the Court's decision eviscerates the claims of many plaintiffs that California law requires lenders and loan servicers to modify loans prior to foreclosure. Second, it provides further support for the proposition that federal banking law preempts any state law that attempts to impose loan terms or related requirements on lenders or servicers.

The Court's decision significantly narrowed the claims of plaintiffs in mortgage cases in other ways as well. To comply with the PMRA, a lender must merely contact the borrower prior to foreclosure about options to possibly avoid foreclosure. In doing so, a lender must "assess" the borrower's situation. Any "'assessment' must necessarily be simple—something on the order of, 'why can't you make your payments?" Id. at *12. "The statute cannot require the lender to consider a whole new loan application or take detailed loan information over the phone." Id. Exploring options to avoid foreclosure, "must necessarily be limited to the traditional ways that foreclosure can be avoided." Id. The PMRA does not require a lender "to engage in a process that would be functionally indistinguishable from taking a loan application in the first place." Id. The lender "does not have any duty to become a loan counselor itself." Id. Moreover, where the borrower is not cooperative, it is sufficient if the lender tried with due diligence to contact the borrower as required by the statute.

The Court also held that the, "only remedy provided is a postponement of the sale before it happens." Id. at *14. If foreclosure has already taken place, there is no remedy. The "Legislature did nothing to affect the rule regarding foreclosure sales as final." Id. at *1. "There is nothing in section 2923.5 that even hints that noncompliance with the statute would cause any cloud on title after an otherwise properly conducted foreclosure sale." Id. at *14. The Court also affirmed the rule that a plaintiff must tender loan proceeds prior to setting aside a foreclosure for irregularities in the sale, but that this rule did not apply here because a plaintiff cannot set aside a foreclosure sale based on a violation of the PMRA. Id. at *8.

Section 2923.5 also requires that any notice of default include a declaration of compliance with the PMRA. The Court held that this declaration need not be made under oath. Id. at *13.

Section 2923.5 also requires that the declaration contain certain other information about the type and substance of the notice, and identifies certain alternative notification language. The Court held that it is sufficient that the declaration "track the language of the statute itself." The declaration can be a form notice listing all the alternative ways that the lender might have complied with the PMRA, even if some of the language is inapplicable to the specific facts. The notice does not need to be "custom drafted." Id. at *14.

Finally, the Court held that in most circumstances claims under the PMRA would be unsuitable for class treatment. Section 2923.5 "contemplates highly-individualized facts" about how a lender contacts a borrower prior to foreclosure and what a lender says or writes about possible options to potentially avoid foreclosure. The Court commented that a class action "might" be appropriate only if a lender had a "clean, systematic policy" uniformly applied. For example, ignoring the statute all together might give rise to a class action, though the Court specifically declined to state whether it would. Id. at *15.

In sum, a plaintiff may enforce rights under the PMRA, but those rights are very narrow and exist only prior to foreclosure. If successful, a plaintiff can merely delay foreclosure until a lender has complied with the statute.

Authored By:

Robert J. Stumpf, Jr.
(415) 774-3288
RStumpf@sheppardmullin.com

and

Shannon Z. Petersen
(619) 338-6656
SPetersen@sheppardmullin.com

Bank Not Liable In Nigerian-Style Email Scam

Question: When a bank sues to recover an overdraft created by a Nigerian-style email scam, which party has the burden of proof on the question of whether, in the context of section 3406 of the Commercial Code, the bank acted negligently—the bank or the overdraft account holder?

Answer: The account holder, according to the Fourth Appellate District, Division Two, in Chino Commercial Bank, N.A. vs. Peters (E049170), decided May 25, 2010.

]]> Oddly enough, this scheme still works sometimes.

Appellant Brian Peters agreed to a proposal that his corporation would receive money supposedly owed to an individual in Malaysia and then pay the money out as directed in exchange for a 15% fee. His corporation received over $800,000 and deposited them in an account at Chino Commercial Bank. The company then had the Bank pay out $468,000. Thereafter, all the checks the company deposited bounced and created an overdraft.

The Bank filed suit against the corporation and Peters (who had signed the account agreement rendering him liable for any account shortage) and obtained a right to attach order against Peters. Ruling for the Bank, the trial court concluded that under section 3406 of the Commercial Code, Peters had the burden of proving the Bank was negligent (which he had not done). It also expressed concern that Peters, despite being negligent himself, "then looks to the bank and says, 'you should have prevented me from doing that.'"

The court of appeal affirmed. It began its analysis by quoting subdivision (a) of section 3406, which states that, "a person whose failure to exercise ordinary care contributes to an alteration of an instrument or to the making of a forged signature on an instrument is precluded from asserting the alteration or the forgery against a person who, in good faith, pays the instrument or takes it for value or for collection." The court held that it was undisputed the Bank was a "person who, in good faith, pa[id] the instrument or t[ook] for value or for collection." The court noted that in this context, "good faith" simply means that the Bank "acted honestly and in accordance with 'reasonable commercial standards of fair dealing.'"

Next, the court of appeal noted there was "ample evidence" that Peters failed to exercise ordinary care and thus contributed to the alteration of the checks. (Indeed, Peters conceded that he was "less than smart in moving forward on the transaction.…") Under subdivision (b) of section 3406, however, if the Bank, too, failed to exercise ordinary care in a way that contributed to the loss, the loss "must be allocated between the Bank and Peters." Citing subdivision (c) of the statute, the court of appeal held that Peters had the burden of proving the Bank was negligent—the Bank was not required to prove it was not negligent. Concluding he had not come close to doing so, the court affirmed the right to attach order.

Authored By:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com

Credit Card Issuer Owes No Duty To Non-Obligor "Cardholder"

Question: "Does a credit card issuer have to resolve disputes about purchases with the consumer who used the card to buy the goods, or just with the person who obtained the card and authorized issuance of another card to the consumer?"

Answer: Just the latter, according to the Ninth Circuit Court of Appeals in Edwards v. Wells Fargo & Company (No. 06-16892), decided May 19, 2010.

]]> In this case, Wells Fargo issued a Visa card to two individuals who signed a form agreeing to be "equally responsible for the repayment of current and future charges on the account.…" Later, these two individuals arranged for the Bank to issue another credit card to plaintiff Edwards, who did not, however, sign a similar form agreeing to be responsible for charges. Edwards later disputed several credit card charges, but Wells Fargo declined to respond to or investigate such disputes on the grounds that it owed no duty to him as a "consumer" under Regulation Z. The district court granted summary judgment in favor of Wells Fargo, and the Ninth Circuit affirmed.

Acknowledging that the Truth and Lending Act requires a credit card issuer to respond to, investigate, and resolve disputes regarding purchases, the Ninth Circuit observed that the "question in this case is to whom that obligation is owed." After a "detour into vocabulary to make the arguments comprehensible," the Ninth Circuit concluded that even though Edwards was a "cardholder" under TILA, he was "not a 'consumer' in the bizarre usage of Regulation Z." Semantics aside, the Ninth Circuit concluded by noting that "it would be quite a big step if the Federal Reserve Board converted a statutory obligation owed only to an 'obligor' under the statutory language into one owed to every college student using a credit card issued to a parent, when the child had a dispute with a pizza parlor."

Indeed.

Authored By:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com

California Statute Regarding Convenience Checks Not Facially Preempted By Federal Law

Question: Is section 1748.9 of the Civil Code, which requires certain disclosures to credit card holders who use preprinted "convenience checks," preempted by the National Bank Act?

Answer: No, according to Fourth District Court of Appeal, Division Three, in Parks v. MBNA America Bank, N.A. (G040798), decided May 12, 2010.

]]> Civil Code section 1748.9 requires credit card issuers who extend credit to cardholders through a "preprinted check or draft," known as "convenience checks" to "disclose on the front of an attachment to the preprinted check that (1) use of the check will constitute a charge against the customer's credit account, (2) the annual percentage rate and calculation of finance charges, and (3) whether the finance charges are triggered immediately upon the use of the check." Plaintiff Parks filed a class action against MBNA for allegedly not making such disclosures. The trial court granted judgment on the pleadings to MBNA on grounds that section 1748.9 was preempted by federal law applicable to national banks.

The court of appeal reversed, concluding that "section 1748.9 is not, on its face, preempted." Specifically, it held that (1) section 1748.9 "does not preclude national banks from exercising their authority to lend money on personal security under section 24 of Title 12 of the United States Code (Seventh)" and (2) "without a factual record," it could not conclude that section 1748.9 "significantly impairs national banks' authorized activities."

Several years into the case, MBNA renewed its previously rejected preemption motion based on the Ninth Circuit's holding in Rose v. Chase Bank USA, N.A. (9th Cir. 2008) 513 F.3d 1032), which on near-identical facts held that federal law preempted section 1748.9 as applied to national banks. The court of appeal noted that although it was not bound to follow federal court precedent, "federal decisions may be particularly persuasive when they interpret federal law." Nonetheless, it reached a different conclusion. Citing Supreme Court that the National Bank Act precludes states from "forbidding, or impairing significantly" the exercise of the power the Act explicitly grants to national banks, the court concluded that "section 1748.9 does not forbid the exercise of a banking power authorized by the NBA." Instead, it was a "generally applicable disclosure law applied to any credit card issuer that extends credit through the use of a preprinted check."

The court noted that there was a question, however, whether section 1748.9 "significantly impairs" the exercise of the power to lend money on personal security. Although it made no ruling on this issue, the court held that national banks claiming preemption on this ground "must make a factual showing that the disclosure requirement significantly impairs the exercise of the relevant power or powers." Accordingly, and although it was "reluctant to create a split of authority with the Ninth Circuit of Appeals on a point of federal law," the court of appeal reversed the judgment in favor of MBNA, leaving open the question of whether MBNA could demonstrate, on remand, that section 1748.9 "imposes burdens on national banks that significant impair the authority granted to it by the NBA."

The bottom line: "there is no basis for preempting section 1748.9 without a factual record."

Authored By:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com

House Approves Legislation to Eliminate Duplicative Consumer Privacy Notices

The U.S. House of Representatives approved by a voice vote on April 14 an amendment to the Gramm-Leach-Bliley Act that will provide an exemption from annual privacy notice updates for financial institutions that do not share non-public consumer information with unaffiliated third parties or make changes to their privacy policies. Currently, a financial institution is required to send out privacy notices annually, even if its privacy policy has not changed and it does not share customer information.]]> The legislation was considered under "suspension of the rules," a process reserved for noncontroversial legislation that limits debate to 40 minutes, bars any amendments, and requires a two-thirds majority vote for passage. The measure bypassed a vote by the House Financial Services Committee and went straight to the House floor, with the blessing of Committee chairman Barney Frank (D-Mass.) and ranking member Spencer Bachus (R-Ala).

There is currently no companion bill in the Senate, but there is at least a reasonable possibility that a companion bill will be introduced into and passed by the Senate during this session.

Authored By:

Sherwin F. Root
(213) 617-5465
sroot@sheppardmullin.com

3rd Circuit Decision Holds That Captive Reinsurance Arrangements Violate Section 8(a) of RESPA

In Alston v. Countrywide Financial Corporation, 585 F.3d. 753 (3rd Cir. 2009), the United States Court of Appeals for the 3rd Circuit held that homebuyers may pursue a class action claim that Countrywide Financial Corporation engaged in taking kickbacks in violation of Section 8(a) of the Real Estate Settlement Procedures Act (RESPA) by steering private mortgage insurance policy referrals to insurers who agreed to reinsure a portion of the policies with Countrywide's affiliate.

]]> Plaintiffs obtained mortgage loans from Countrywide. Because plaintiffs' down payment was less than 20%, Countrywide required plaintiffs to purchase private mortgage insurance. The rates charged by mortgage insurers in Pennsylvania are set by the Pennsylvania Insurance Department. Countrywide allegedly required the plaintiffs to purchase their mortgage insurance only from one of a number of insurers who agreed to reinsure a portion of the policies with Countrywide's affiliate, Balboa Reinsurance Company. Because insurance rates are fixed, the plaintiffs paid the same amount for the private mortgage insurance as they would have paid had they selected their own insurer.

Balboa entered into a reinsurance arrangement with the mortgage insurers where in return for a portion the premiums, Balboa agreed to be responsible for a band of losses under the reinsurance policies. Plaintiffs alleged this "excess loss agreement" was a disguised kickback because Balboa did not assume risk commensurate with the premiums it received. They supported this allegation with evidence that since 1999, Balboa had collected over $892 million in premiums but had paid nothing in claims.

The District Court dismissed plaintiffs' claims on grounds the plaintiff homebuyers could not establish they suffered any loss. The Third Circuit reversed, holding that RESPA does not require a plaintiff to allege or prove it suffered any actual loss from the alleged kickback, but merely that a kickback existed. The Court also rejected Countrywide's defense that the rates the private insurance companies charged were necessarily reasonable because they were set by the state, noting that “plaintiffs challenge Countrywide's allegedly wrongful conduct, not the reasonableness or propriety of the rate that triggered that conduct.”

For some time, HUD has questioned the propriety of this type of captive reinsurance arrangement. [First name of opinion, in italics] also brings into doubt the validity of captive reinsurance arrangements based on excess loss agreements unless the mortgage lender can establish the captive reinsurer actually paid out a reasonable amount in losses. In addition, the Court's reasoning could apply in the context of HUD's requirements for affiliated business arrangements (AfBAs). From time to time, HUD has argued that an AfBA where a business partner receives distributions that are not commensurate with the risks it incurs is really a disguised kickback (and therefore a sham arrangement) in violation of RESPA because it, too, does not appropriately reflect market risks and rewards of the market.

Authored By:

Sherwin F. Root
(213) 617-5465
sroot@sheppardmullin.com

Ninth Circuit Court of Appeals Joins Other Circuits And Holds That Overcharge Does Not Violate Section 8(b) of RESPA

The United States Court of Appeals for the Ninth Circuit, which includes California, issued a ruling on March 9 that the clear and unambiguous language of RESPA Section 8(b) does not reach the practice of overcharging. Martinez v. Wells Fargo Home Mortgage, Inc. Section 8(b) of RESPA states that "no person shall give and no person shall accept any portion, split, or percentage of any charge made or received for the rendering of a real estate settlement service in connection with a transaction involving a federally related mortgage loan other than for services actually performed."

]]> The Martinezes refinanced their California home mortgage loan through Wells Fargo, which charged them an $800 underwriting fee. The Martinezes alleged that the fee was excessive because it was not reasonably related to Wells Fargo's actual costs of performing the underwriting, and therefore violated both Section 8(b) of RESPA and California's unfair competition law, Section 17200 of the California Business & Professions Code. Note that the Court was not presented with a set of facts that no services were provided. Instead, the allegation was that even if services were provided, a portion of the fee represented an illegal overcharge. The District Court dismissed the Martinez's claims. The Ninth Circuit affirmed. It first held that because the alleged overcharge was for the services actually rendered by Wells Fargo, it did not violate Section 8(b). The Ninth Circuit thus joins the Second, Third, and Eleventh Circuits in holding that alleged overcharges do not violate Section 8(b).

Next, the Court held the Martinezes Section 17200 claims were preempted by regulations promulgated by the Office of the Comptroller of the Currency. The Martinezes had alleged that the overcharging by Wells was an unfair practice, but the Court held that this claim was preempted by an OCC regulation that permits each bank governed by the OCC to use its business judgment to set its own fees within its discretion, according to sound banking judgment and safe and sound banking principles (12 Code of Federal Regulations, Section 7.4002(b)(2)). The Court said it would not decide how much an appropriate underwriting fee would be, since this is a business decision to be made by each bank. The Martinezes had also alleged that Wells Fargo had engaged in a fraudulent practice by not disclosing the actual cost of underwriting their loan, but the Court held this claim to be preempted by an OCC regulation that permits a national bank to make real estate loans without regard to state law limitations concerning disclosure and advertising (12 Code of Federal Regulations, Section 34.4(a)). Note that that had Wells Fargo been a state-chartered lender, the Court might have reached a different conclusion.

Comment: Although this holding is welcome news, settlement service providers still need to carefully consider their approach on pricing. We suggest they think about these issues in establishing policies on pricing of settlement services subject to RESPA: (a) document the services the fee is intended to cover (e.g., a mortgage broker should not charge a loan funding fee), (b) consider prevailing market rates for the service (and avoid being a "high price" leader), (c) consider the internal costs to perform the work, (d) ensure that employees and vendors understand the services the payment is intended to cover and that they understand how the fee should be disclosed (including on the GFE and HUD-1), (e) avoid wide variations in the fee (e.g., don't categorically exclude certain borrowers from the fee), (f) make sure the fee description is clear and easy to understand, (g) don't mark up third party fees, (h) make sure to understand any state or federal law limitation on types of fees, (i) if the fee is for a service for which the consumer can shop, make sure the consumer understands that he or she can do so, and (j) make sure that the service for which the fee is charged does not duplicate another settlement service provider's fee. Of course, you should always consult with legal experts on these issues.

Click here to read the decision.

Authored By:

Sherwin F. Root
(213) 617-5465
sroot@sheppardmullin.com

FHA Proposes Higher Net Worth Requirement For Lenders In Effort To Strengthen Risk Management

The Federal Housing Administration has issued a proposed rule that would increase the net worth requirements for approved mortgage lenders and hold them responsible for the lending actions of affiliated mortgage brokers. Currently, the FHA requires approved mortgage lenders to have a net worth of at least $250,000. The proposed rule would require such lenders to maintain a minimum of $1 million in net worth within the first year and at least $2.5 million of net worth within three years of the effective date of the rule. The FHA stated that these changes are consistent with industry standards and will ensure that FHA lenders are sufficiently capitalized to meet potential needs, thereby permitting the FHA to mitigate losses and decrease risks to its insurance fund.

]]> In addition, the FHA has proposed that FHA-approved mortgage lenders assume liability for all the loans they originate and/or underwrite. While loan correspondents (i.e., mortgage brokers) would be able to continue originating FHA-insured loans through their relationships with approved mortgage lenders under the new rule, they would no longer receive independent approval for origination eligibility. FHA-approved mortgage lenders would therefore be required to assume responsibility and liability for the FHA-insured loans underwritten and closed by the mortgage brokers. The FHA stated that these changes would align FHA with Fannie Mae and Freddie Mac and will potentially increase the number of loan correspondents (mortgage brokers) who are eligible to participate in the origination of FHA-insured loans while providing for more effective oversight of loan correspondents through the FHA-approved mortgage lenders.

Authored By:

Sherwin F. Root
(213) 617-5465
sroot@sheppardmullin.com

Joint Venture Exception to the Usury Laws

In Junkin v. Golden West Foreclosure Service, Inc. (Jan. 5, 2010) 180 Cal.App.4th 1150, the First District Court of Appeal affirmed the trial court's finding that because the transaction involved was a joint venture, it was exempted from the usury laws.

]]> In this case, Donald L. Junkin III filed a complaint against Golden West Foreclosure Service, Inc. and Garry Bennett to enjoin the threatened foreclosure of an office building in San Carlos under an allegedly usurious promissory note and deed of trust held by Bennett. Junkin, a licensed real estate agent, has owned and operated several real estate agencies and mortgage brokerage companies. "Bennett was a 'hard money' lender who specialized in providing money quickly at high rates" and Junkin had borrowed from Bennett and invested in property jointly with Bennett on numerous prior occasions.

In 2004, Junkin and Bennett purchased commercial property together and were jointly obligated on a loan from an institutional lender. In addition, Bennett loaned Junkin $856,000 to cover the remainder of the purchase price and in return received a promissory note, carrying an interest of 12%, secured by a deed of trust in favor of Bennett. Junkin and Bennett both held title to the property and considered themselves to be partners in the venture. Further, Junkin owned a 90% interest and Bennett owned a 10% interest in the property. After a sequence of failed payments by Junkin to Bennett, Bennett quitclaimed his 10% interest back to Junkin and later retained Golden West Foreclosure Service, Inc. to foreclose on the property.

Junkin filed a complaint against Golden West and Bennett, alleging that his promissory note was usurious and the foreclosure was unlawful. Bennett argued that "even if the interest rate on the loan could be characterized as usurious, there was no usury under the joint venture exception to the usury laws." The trial court found that the joint venture exception was applicable and entered judgment in favor of defendants.

The court of appeal affirmed the judgment. It began its analysis by examining the usury laws. Usury is defined as "the charging of interest for a loan or forbearance on money in excess of the legal maximum." 8 Miller & Starr, Cal. Real Estate (3d ed. 2001) § 21:1, p.4, fn. omitted. The maximum amount that may be charged in California is set forth in the Constitution. See Cal. Const., art XV, § 1. The court noted that while many exceptions to the usury law exist, only the joint venture exception was at issue in this case. Quoting a leading treatise, the court explained that, "where the relationship between the parties is a bona fide joint venture or partnership, the advance by the partners or joint venturers is an investment and not a loan, and the profit or return earned by the investor is not subject to the statutory maximum limitations of the Usury Law." 8 Miller & Starr, Cal. Real Estate, supra, § 21:1, p.48, fn. omitted.

Citing to Miller & Starr, the court identified several factors relevant to determining whether a transaction is a bona fide joint venture: (1) whether there is an absolute obligation of repayment (Junkin was obligated to repay the note in favor of Bennett), (2) whether the investor may suffer a risk of loss (Bennett assumed a risk of the loss of capital), (3) whether the investor has any right to participate in management (even though Bennett did not participate in the management, the court viewed this as his personal choice rather than anyone preventing him from doing so), (4) whether the subject property was purchased from a third party (as in this case), and (5) whether the parties considered themselves to be partners in the transaction (both Junkin and Bennett testified they considered themselves to be partners). Applying these factors, the court affirmed the judgment, holding that because a joint venture existed, the joint venture exception to the usury rules applied.

This case highlights the importance of carefully considering how loans involving a joint venture are structured as well as the entity that will be used to make the loan. For example, if Bennett had used a family trust or other entity to make the loan to Junkin, it is not clear if the court would have reached the same conclusion.

For further information, please contact Allison Berkley at (213) 617-5521.

Preemption Not Dead: Servicers of Student Loans Achieve Significant Victory in Ninth Circuit Preemption Case

In Chae v. SLM Corporation, No. 08-56154 (9th Cir. January 25, 2010), the U.S. Court of Appeals for the Ninth Circuit held that the federal Higher Education Act (the "HEA") preempts student borrowers' ("Plaintiffs") claims that Sallie Mae, Inc.'s ("Sallie Mae") interest rates, late fees, and payment schedules violate California law.

]]> Plaintiffs in this action took out Stafford, Supplemental, and Consolidated Loans from various lenders between 1993 and 2006, and Sallie Mae was the loan servicer for each of these loans. As a third-party servicer, Sallie Mae carried out administrative and servicing functions relating to the loans, including issuing billing statements, collecting and processing payments, assessing and collecting late fees, and giving notice to borrowers as required by the Federal Family Education Loan Program (the "FFELP") regulations. Plaintiffs specifically challenged three practices used by Sallie Mae in servicing student loans: (1) Sallie Mae's use of "simple daily interest" method of calculating interest instead of the "installment method" which is required by their loan contracts; (2) Sallie Mae's practice of assessing late fees – mainly, when permitted by a borrowers' promissory note, Sallie Mae charges a late fee of up to six percent of each installment remitted more than 15 days after it is due and Plaintiffs argue that California law prohibits the charging of late fees where there is also a simple daily interest charge; and (3) Sallie Mae's method of setting the first repayment date on a Consolidation or PLUS loan within 60 days after disbursement and charging interest during that period of up to 60 days – Plaintiffs allege that this amounts to deceptively increasing the cost and life span of the loan. Essentially, Plaintiffs argued that Sallie Mae's loan-servicing practices violate California business, contract, and consumer-protection law.

The Ninth Circuit began its analysis by reviewing the purpose of the HEA. The HEA was passed "to keep the college door open to all students of ability, regardless of socioeconomic background." Rowe v. Educ. Credit Mgmt. Corp., 559 F.3d 1028, 1030 (9th Cir. 2009). To uphold this goal, Congress established the FFELP, which is a system of loan guarantees meant to encourage lenders to loan money to students and their parents on favorable terms. See 20 U.S.C. §§ 1071-1087-4; Rowe, 559 F.3d at 1030. Further, the Secretary of the Department of Education (DOE) is authorized to "prescribe such regulations as may be necessary to carry out the purposes" of the FFELP. 20 U.S.C. § 1082(a)(1).

The Supremacy Clause of the Constitution provides that federal law "shall be the supreme Law of the Land." U.S. Const. art. VI, cl. 2. Further, the United States Supreme Court has recognized that "state laws that conflict with federal law are 'without effect.' " Altria Group, Inc. v. Good, 129 S. Ct. 538, 543 (2008) (quoting Maryland v. Louisiana, 451 U.S. 725, 746 (1981)). In this case, the court found that two types of federal preemption – "express" and "conflict" – act to block the class claims brought by Plaintiffs.

Under express preemption, Congress may indicate its intent to displace state law through express language. Altria Group, 129 S. Ct. at 543. The court found that Congress enacted several express preemption provisions applicable to the FFELP participants. One such provision, 20 U.S.C. § 1098g, titled "Exemption from State Disclosure Requirements," states that "loans made, insured, or guaranteed pursuant to a program authorized by Title IV of the Higher Education Act . . . shall not be subject to any disclosure requirements of any State law." Because the FFELP falls within Title IV of the HEA, the court found that it is subject to this express preemption provision. Accordingly, the court held that two of Plaintiffs' claims – (1) using billing methods to trick borrowers into thinking the installment method is being used and (2) improper disclosure regarding the method of setting repayment date – which fall under the Unfair Competition Law, are precluded by express preemption.

As for conflict preemption, a state law, whether arising from statute or common law, is preempted if it creates an “obstacle to the accomplishment and execution of the full purposes and objectives of Congress.” Crosby v. Nat'l Foreign Trade Council, 530 U.S. 363, 373 (2000) (quoting Hines v. Davidowitz, 312 U.S. 52, 67 (1941)). As previously stated, the main purpose of the FFELP is "to encourage states and nonprofit private institutions and organizations to establish adequate loan insurance programs for students in eligible institutions." 20 U.S.C. § 1071(a)(1)(A). Thus, the court found that in order to accomplish the goal of encouraging such lending, Congress intended the core aspects of the FFELP to be uniform, establishing a set of rules that would apply across the board. Accordingly, the court reasoned that the only way for the loan program to remain viable is to ensure its stability. Additionally, the court explained that if the law were to allow Plaintiffs' California state law claims, this would in effect promote similar claims being asserted in each of the other states and thus "impair and threaten the efficacy of the federal lending effort for students." Therefore, the court stated that Plaintiffs' second claim, that California law prohibits imposition of a late fee when daily simple interest is used, creates an obstacle to the uniform regulatory system that permits late fees.

The court concluded its opinion by stating the following: "In conclusion, the Plaintiffs’ allegations that Sallie Mae makes fraudulent misrepresentations in its billing statements and coupon books are expressly preempted by the HEA, and conflict preemption prohibits the Plaintiffs from bringing their remaining claims because, if successful, they would create an obstacle to the achievement of congressional purposes. Having carefully considered the FFELP and the purposes of Congress in the HEA, we conclude, beyond any doubt, that subjecting the federal regulatory standards to the potentially conflicting standards of fifty states on contract and consumer protection principles would stand as a severe obstacle to the effective promotion of the funding of student loans. Such an obstacle, which we consider hostile to the purposes of Congress in this program, must bow to the overriding principles of conflict preemption and federal law supremacy."

This ruling in favor of Sallie Mae, the nation's largest servicer of student loans, is beneficial to third-party servicers and lenders in the Ninth Circuit that service their own loans, as it provides a shield from state law claims. This case stands to show that despite the political climate, preemption is not dead. Additionally, in student lending industries, the economic efficiencies that are provided and applied across the 50 states still exist.

For further information, please contact Allison Berkley at (213) 617-5521.

Bank May Seek Attachment On Unsecured Guaranty Even If Principal Loan Is Secured

Question: May a Bank who made a construction loan secured by real property seek a right to attach order and writ of attachment against a third party guarantor on its unsecured guaranty security?

Answer: Yes, according to the Fourth District Court Of Appeal, Division Three, in United Central Bank v. Superior Court (G042247), decided November 17, 2009.

]]> In this case, a third party guarantor provided three personal guaranties to the Bank as additional credit support for construction loans the plaintiff Bank made to another party. The construction loans–but not the guaranties–were secured by deeds of trust on real property. When the Borrower defaulted, the Bank demanded the guarantor pay the amounts due under its guaranties. The guarantor refused, and the Bank applied to the trial court for a right to attach order and writ of attachment.

The trial court denied the Bank's application, citing section 483.010 of the Code of Civil Procedure for the proposition that "writs of attachment do not pertain to situations where the loan or loans are secured by real property. . . ." The Court of Appeal reversed, holding that the trial court misapplied section 483.010. Although that section does provide that an attachment "may not be issued on a claim which is secured by any interest in real property," the Fourth District noted the trial court "failed to recognize that the 'claim' before it was based on unsecured guaranties."

The Court added that, "[c]ase law holds that a writ of attachment may issue on a guaranty, regardless of whether the principal loan is secured, so long as the guarantor has waived the right to require the creditor to proceed first against the security given for the primary obligation." This holding is, of course, unremarkable. Indeed, the trial court's error was so apparent that the Court of Appeal issued a peremptory writ of mandate in the first instance, holding that the Bank's entitlement to the relief it requested "is so obvious that no purpose could be served by plenary consideration of the issue."

Having determined the trial court should have considered the merits of the Bank's application, the Fourth District remanded the matter to the trial court with instruction to conduct a new hearing to consider whether the Bank had, in fact, made a sufficient showing for issuance of the right to attach order.

Authored By:

Robert J. Stumpf, Jr.
(415) 774-3288
rstumpf@sheppardmullin.com