Sheppard Mullin Financial Institutions Law Blog

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

MORE BAD NEWS FOR MORTGAGE LENDERS? PMI COMPANIES ATTEMPTING TO RESCIND INSURANCE POLICIES

The last few years have presented many challenges for mortgage lenders. The latest challenge may be coming from an unlikely source - private mortgage insurance policies. Private mortgage insurance, or PMI, is the insurance that mortgage lenders purchase, or cause their borrowers to purchase, when the borrower does not make a down payment of at least 20% when purchasing a home. The PMI policy is intended to protect the lender in the event of a default by the borrower.

]]> With so many mortgage loans in default today, PMI companies are likely facing the risk of significant liabilities. As a result, PMI companies are attempting to rescind many PMI policies, even though the policies were purchased and paid for years ago, may have been required by law, and were integral to the lender's decision to approve the borrower's loan application. The PMI companies are taking the position that they have discovered extensive amounts of fraud and misrepresentation by policyholders during the application process.

Some level of rescissions for fraud is commonplace in this industry. However, it appears that rescissions are reaching an unprecedented level. For example, in its first-quarter earnings call on April 29, 2009, the MGIC Investment Corporation reported:

"Historically, claims submitted to us on policies we rescinded were less than 5 percent of our claims resolved during a year. This increased to approximately 15 percent in the fourth quarter of 2008 and was over 20 percent in the first quarter of 2009. Rescissions have materially mitigated our paid losses in 2008 and 2009."

In its second quarter earnings call, MGIC did not report on the percentage of claims submitted in the second quarter that were rescinded, but it did state that the dollar amount of rescinded loans in the second quarter was more than 40% higher than the dollar amount of rescinded loans in the first quarter, which would indicate that the number of rescinded loans is continuing to escalate rapidly.

Of course, the PMI companies recognize that this approach (i.e., for MGIC a quadrupling of rescissions over the normal rate) will not go unchallenged. The MGIC spokesperson went on to state that "while we have a substantial pipeline of claims investigations that we expect will eventually result in rescissions during the second and third quarters of 2009, we can give no assurance that rescissions will continue to mitigate paid losses at the same level we have recently experienced. In addition, if the insured disputes our right to rescind coverage, whether the requirements to rescind are met ultimately would be determined by arbitration or judicial proceedings. Objections to rescission may be made several years after we have rescinded an insurance policy."

By increasing rescissions in this manner, PMI companies are attempting to avoid being held accountable for the consequences of their decisions, and leave their policyholders holding the bag.

Authored By:

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

New FCA Rules Put Lenders and Brokers Directly in Their Gun Sights

The author is a member of the Firm's Government Contracts & Regulated Industries Practice Group. For additional articles and postings concerning this and related topics, please refer to Sheppard Mullin's Government Contracts Blog, which can be found at www.governmentcontractslawblog.com.

I. INTRODUCTION

Without a doubt, the False Claims Act ("FCA") has been dramatically changed in the last few months. As will be discussed in more detail herein, it certainly appears that the FCA has been retooled so that the playing field is now stacked in favor of the government and qui tam plaintiffs. There is also every indication that lenders who have federally insured mortgages, redevelopment funding, or other financial support from the government, are at risk of being sued for false claims unless they take certain precautions to educate and protect themselves.

]]> In fact, it is a good idea for all companies who receive government funding (e.g., defense contractors, health care providers, academic institutions) to look closely at their internal compliance programs, and modify them to reflect the recent changes in the FCA. This article is intended to offer some specific suggestions, and also encourage companies to have their programs amended, and implemented by legal counsel who are receptive to flexible billing arrangements including flat fee schedules.

II. MANY OF THE HURDLES TO LITIGATING FALSE CLAIMS ACTIONS HAVE BEEN REMOVED

The following are some of the more significant changes to the FCA:

(1) There is essentially no time bar for the government to intervene in the private party ("relator") action – the government can easily have its complaint relate back to the timely filing of the relator action.

(2) The government can now essentially "deputize" private parties and local governments to aid in the pursuit of these actions, by sharing documents and testimony that the government has obtained through Civil Investigative Demands ("CIDs"). The FCA now expressly authorizes the sharing of information obtained under a CID with "any qui tam relator," with federal, state or local government agencies, and with other interested persons (i.e., courts, consultants, auditors, experts, arbitrators) if it is done in connection with an investigation, case or proceeding. Thus, it is even more important now to involve legal counsel early on in negotiating the parameters of the CID, and coordinating the company's response.

(3) The universe of potential relators has been expanded dramatically, and can include contractors and agents, all of whom appreciate the considerable financial windfall that relators recover in qui tam actions with treble damage awards. Since the 1986 amendments, qui tam plaintiffs have accounted for more than half of the over $21.5 billion recovered under the FCA, with the plaintiffs recovering anywhere from 15-30% of the government's recovery. Thus, companies need to worry not only about disgruntled and terminated employees who may recast themselves as possible "whistleblowers," but also contractors with whom relations have become strained for any reason. The FCA anti-retaliation provision now applies to contractors and agents in addition to employees.

(4) Subcontractors or others who submit a bill for payment to a recipient of government funds can now be held liable under the FCA, even if their bill is not submitted to the government directly. The definition of "claim" in the FCA has been expanded to include these indirect claims, so long as the funds involved are used on behalf of the government or in furtherance of a government program or interest. For example, in the context of federally insured mortgages, the government support is provided based on a private entity certifying that the borrower has complied with a variety of criteria underlying the loan agreements, any of which could form the basis of a false claims action, even if the certifying entity is not submitting a claim to the government.

(5) In amending the FCA, Congress specifically rejected several court decisions that made it more difficult for plaintiffs to establish liability. For example, the Allison Engine requirement that a claim or statement must be designed "to get" false claims paid or approved has been relaxed considerably, with the FCA amendments:

These amendments to Section 3729 clarify that the False Claims Act was intended to extend to any false or fraudulent claim for government money or property, whether or not the claim is presented to a government official or employee, whether or not the U.S. Government has physical custody of the money, and whether or not the defendant specifically intended to defraud the U.S. government. With this change, the additional elements read into the statute by the Supreme Court and the D.C. Circuit decisions are vitiated, and Allison Engine and Totten would be overturned by this legislative action.

February 5, 2009, Statement of Sen. Patrick Leahy, Chairman, Senate Judiciary Committee, Introduction of Fraud Enforcement and Recovery Act of 2009. Thus, the specific intent element that the United States Supreme Court imposed in Allison Engine, to keep FCA enforcement from becoming effectively "boundless," has been removed. To establish FCA liability now, the plaintiff only needs to prove that the false statement was "material" to the government's decision to pay a false claim. "Material" is defined loosely as "having a natural tendency to influence, or be capable of influencing, the payment or receipt of money or property."

In addition, there are further amendments moving through Congress that would also increase the number of FCA plaintiffs. Most significantly, the "public disclosure" defense to qui tam suits would be greatly weakened by eliminating the FCA defendant's right to move to dismiss a relator complaint based on the public disclosure bar. Further, the bills would redefine what constitutes "public disclosure" to make it more narrow, and also allow a court to dismiss a qui tam action only if the "allegations relating to all essential elements of liability of the action or claim are based exclusively on the public disclosure of allegations or transactions…." When viewed in the context of the vast amount of public information that is available through the Internet, the elimination of this defense for defendants could exponentially increase the number of private plaintiff suits. Given the speed with which the recent amendments were approved by Congress and signed by the President, there should be little doubt that further amendments in favor of qui tam plaintiffs are just a matter of time.

III. THE GOVERNMENT IS TARGETING THE MORTGAGE LENDING BUSINESS, AND USING THE FCA TO DO IT

These changes also come with considerable bite behind them with the government approving substantial spending budgets for enforcement purposes. The bill authorized $155 million a year for hiring fraud prosecutors and investigators at the Justice Department for fiscal years 2010 and 2011, with the expectation that the FBI can double the number of its mortgage fraud task forces nationwide – from 26 to more than 50.

Finally, if there is any remaining doubt that the FCA is a powerful tool that the government is using to prosecute mortgage fraud, then the following remarks are worth considering, in addition to the cases that the government has been litigating in the last year. In introducing the Anti-Fraud Legislation that included the amendments to the FCA, Senator Patrick Leahy said, "The federal government has spent hundreds of billions of dollars to stabilize our banking system, and Congress will soon spend even more to restart our economic recovery. But to date, we have paid far too little attention to investigating and prosecuting the mortgage and corporate frauds that has so dramatically contributed to this economic collapse." Similarly, President Barack H. Obama in signing the bill stated: "This bill nearly doubles the FBI's mortgage and financial fraud program, allowing it to better target fraud in hard-hit areas. That's why it provides the resources necessary for other law enforcement and federal agencies, from the Department of Justice to the SEC to the Secret Service, to pursue these criminals, bring them to justice, and protect hardworking Americans affected most by these crimes."

Recent cases are a good indication of the mortgage industry practices that are coming under scrutiny. In June 2009, Beazer Homes USA Inc. agreed to pay $5 million to the United States, plus contingent payments of up to $48 million dollars to be shared with victimized private homeowners, to resolve allegations that Beazer Mortgage Company was involved in fraudulent mortgage origination activities with federally insured mortgages. Beazer allegedly induced unqualified home buyers to enter into Federal Housing Administration ("FHA") insured mortgages, and, then, when the buyers defaulted, the FHA was wrongfully required to pay on the mortgage insurance claims.

Similarly, mortgage lenders who offer HUD-insured mortgages are becoming the subject of false claims actions. In this scenario, the HUD approved lender can "directly endorse" a mortgage for low and middle-income buyers under certain conditions, but can be held liable if the lender submitted unqualified loans to the HUD for insurance endorsement, without disclosing that the loans did not satisfy FHA guidelines. (Nat'l City Mortgage, June 2, 2008, $4.6 million settlement; and RBC Mortgage, November 25, 2008, $10.71 million settlement).

Presently pending in the United States District Court in Los Angeles, California is an action against mortgage lender Capmark Finance, Case No. CV 09-04104 RSWL (JCx), in which, the government is seeking to recover damages and penalties under the FCA arising from Capmark's submission of allegedly false documents and claims to HUD's multifamily mortgage insurance program. Specifically, the complaint alleges that Capmark engaged in fraudulent conduct to obtain HUD mortgage insurance in connection with two loans made by Capmark that financed the borrowers' acquisition of two existing residential nursing home facilities. When the loans defaulted, HUD sustained losses by having to pay $25.9 million dollars in mortgage insurance claims. In the Department of Justice press release for the Capmark case, the Department of Justice representative stated, "Mortgage fraud is a top priority for this Administration, especially when public dollars are at stake. We will aggressively pursue fraud claims against federal mortgage insurance programs, which are so vitally important to this economy." Thus, all loans at risk of default that are covered by government mortgage insurance are ripe for possible false claims actions.

IV. IT IS A PRUDENT BUSINESS PRACTICE FOR COMPANIES, INCLUDING THE MORTGAGE LENDING SECTOR, TO PROTECT THEMSELVES THROUGH EFFECTIVE COMPLIANCE PROGRAMS AND REGULAR INTERNAL AUDITS

There are a number of reasons why it is in a company's best interest to have a current and effective compliance program in place. Early discovery of possible FCA violations can create opportunities for voluntary disclosure, provide a basis for resolving the problems through a negotiated settlement, and shorten the damages time period by identifying problems early on. In light of the recent amendments to the FCA, compliance programs should be updated along the following lines, with additional modifications tailored to the particular needs of the company:

(1) Schedule internal audits of all agreements that involve federal funds that may be at risk, including, without limitation, federally insured loans to at risk borrowers.

(2) Establish an alert system for identifying agreements where the payments are overdue, and there is a risk that the contract will be breached, or the property foreclosed in the case of a mortgage loan.

(3) Establish an audit system of agreements involving subcontractors with whom the company has either terminated the relationship, or the relationship has become strained, in order to ensure that the underlying agreements were handled properly and, therefore, there is no basis for a qui tam complaint by a subcontractor or, alternatively, any problems can be identified and addressed.

(4) Evaluate the advantages and disadvantages of having a hotline system for contractors and agents to report FCA concerns, now that they are included in the class of possible qui tam plaintiffs.

(5) Remind all company departments that prompt notice to management upon receipt of any subpoena or government inquiry is essential. Now that the documents and testimony produced in response to a CID can be shared more broadly, it is even more critical that companies work with legal counsel in complying with these requests.

For further information concerning our Government Contracts Practice, contact our Practice Group Leaders, Bryan Daly in Los Angeles at (213) 617-5466 and Anne Perry in Washington, D.C. at (202) 218-6875.

Authored by:

Michelle Sherman
(213) 617-5405
msherman@sheppardmullin.com

and

Peter Morris
(213) 617-5414
pmorris@sheppardmullin.com

New Regulation Z Proposal Bans Yield Spread Premiums, Revamps Disclosure Requirements

The Federal Reserve Board on July 23 proposed significant changes to Regulation Z, the Truth in Lending Act regulation, including new consumer protections for receiving home mortgages and home equity lines of credit. These changes include a prohibition of payments to a mortgage broker or loan officer that are based on the loan's interest rate or other terms (often referred to as "yield spread premiums" or "overages"), and a prohibition of a mortgage broker or loan officer "steering" consumers to transactions that are not in the consumer's best interest in order to increase the mortgage broker's or loan officer's compensation. The Board maintains that consumers rely on the professional expertise of brokers and other loan originators and expect they will act fairly. These expectations, however, are not met when the consumer is steered into a more expensive loan. As a result, the Board's proposal went beyond disclosure revisions and suggested these substantive protections. However, the proposal stopped short of imposing on the originator a fiduciary duty to the customer. Such a responsibility would require that the originator find the “best” loan to meet a consumer's requirements. The proposal only prohibits the originator from steering a customer to a more expensive or risky loan to increase the originator's own fees, but does not require the extra step of requiring the originator to seek out the best available loan product.

]]> These proposals do not make any distinction between payments by a creditor to third parties (such as brokers), and payments by the creditor to its employees (e.g., loan officers). In addition, the proposal would prohibit the broker from receiving additional compensation from the creditor (or any other third party) if the broker is paid directly by the consumer, which could affect the consumer's ability to finance his or her payments to the broker. Finally, the Board is seeking comment on whether it should be permissible for creditors to compensate brokers or loan officers based on loan amount.

The Board's proposal includes numerous changes to the current Regulation Z disclosure requirements, including the following for closed end mortgage loans:

Disclosures at Application

Providing a new one-page Board publication which would explain the potentially risky features of a mortgage loan;

Providing a new one-page Board publication which would explain the basic differences between fixed and adjustable rate mortgage loans and would replace the Consumer Handbook on Adjustable-Rate Mortgages;

Revising the format and content of current adjustable rate mortgage loan program disclosure, including a requirement that the disclosure be in a tabular question and answer format, a streamlined plain language disclosure of interest rate and payment information, and a new disclosure of potentially risky features, such as prepayment penalties.

Disclosures within Three Business Days after Application

Revising the calculation of the finance charge and the annual percentage rate (APR) so that they better capture most fees and costs paid by consumers in connection with the credit transaction;

Providing a graph that would show consumers how their APR compares to the APRs for borrowers with excellent credit and for borrowers with impaired credit;

Requiring disclosure of potential changes to the interest rate and monthly payment;

Disclosing total settlement charges, as is currently required for the Good Faith Estimate under the Real Estate Procedures Settlement Act (RESPA) and Regulation X;

Summarizing key loan features, including the loan term, amount and type;

Adopting new format requirements, including rules regarding type size, use of bold face for certain terms, placement of information, and highlighting certain information in a tabular format.

Disclosures Three Business Days before Consummation

Requiring creditors to provide a final TILA disclosure that the consumer must receive at least three business days before consummation. In addition, the Board has asked for comments on two proposed alternatives:

1. If any terms change after the final TILA disclosure is provided, then another final TILA disclosure would need to be provided that the consumer must receive at least three business days before consummation; or

2. If the APR exceeds a certain tolerance or an adjustable rate feature is added after the final TILA disclosure is provided, then another TILA disclosure would be provided that the consumer must receive at least three business days before consummation. All other changes could be disclosed at consummation.

Disclosures after Consummation

Increasing the advance notice of a payment change for an adjustable rate mortgage loan from 25 to 60 days, and revising the form and content of interest rate adjustment notices;

For loans with negative amortization, requiring a monthly statement to provide information about payment options that include the costs and effects of negatively amortizing payments;

For creditor-placed property insurance, requiring notice of the cost and coverage of such insurance at least 45 days before imposing a charge for the insurance.

For home equity lines of credit (HELOCs), the Board's proposals include the following:

Disclosures at Application

Eliminating the requirement to provide a multiple-page disclosure of generic rates and terms of the creditor's HELOC products, as well as the requirement to provide a Board-published lengthy brochure explaining HELOC products and risks;

Requiring the creditor to provide a new one page Board publication summarizing basic information and risks regarding HELOCS.

Disclosures within Three Business Days after Application

Providing information about rates and fees, payments, and risks in a tabular format;

Highlighting whether the consumer will be responsible for a balloon payment;

Presenting payment examples based on both the current rate available and the maximum possible rate for the HELOC.

Disclosures at Account Opening

The proposal would retain the existing requirement to provide consumers with transaction-specific information about rates, terms, payments, and risks at the time of account opening. To facilitate comparison, the proposal would prescribe formatting for this information similar to that of the proposed disclosure provided within three business days after application.

Periodic Statements

Eliminating the disclosure of the effective APR;

Grouping interest charges and fees separately and requiring disclosure of separate totals of interest and fees for both the period and the year to date.

Change-in-Terms Notices

Increasing advance notice of a change in a HELOC term from 15 to 45 days in advance of the effective date of the change.

Account Terminations

Prohibiting creditors from terminating an account for payment-related reasons until the consumer has failed to make a required minimum periodic payment for more than 30 days after the due date for that payment.

Suspensions and Credit Limit Reductions

Establishing a new safe harbor for suspending or reducing a line of credit based on a "significant" decline in property value. For HELOCs with a combined loan-to-value ratio at origination of 90% or higher, a 5% decline in the property value would be "significant;"

Providing additional guidance regarding the information on which a creditor may rely to take action based on a material change in the consumer's financial circumstances, such as the type of credit report information that would be appropriate to consider.

Reinstatement of Accounts

Requiring additional information in notices of suspension or reduction about consumers' ongoing right to request reinstatement and creditors' obligation to investigate the request;

Requiring creditors to complete an investigation of a request within 30 days of receiving a request for reinstatement and to give a notice of the investigation results to consumers whose lines will not be reinstated.

The public will have 120 days after publication of these proposals in the Federal Register, which is expected shortly, to provide comments on these proposals.

The Board also announced that it will work with HUD to make the disclosures mandated by TILA and HUD's disclosures required by RESPA complementary, potentially developing a single disclosure form that creditors could use to satisfy both laws.

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

When Is A Loan Sale A Table-Funded Transaction Subject To RESPA? U.S. District Court In California Casts Doubt On Routine Transactions

Section 3500.5(b)(7) of Regulation X states that a bona fide transfer of a loan obligation in the secondary market is not covered by the Real Estate Settlement Procedures Act (RESPA). That section goes on to state that "in determining what constitutes a bona fide transfer, HUD will consider the real source of funding and the real interest of the funding lender."

]]> Mortgage bankers that do not have their own internal source of financing for mortgage loans typically obtain financing from warehouse lenders. The mortgage banker will use loan proceeds from the warehouse lender to fund mortgage loans, and will promptly sell the mortgage loan to an investor, using the proceeds of the sale to the investor to repay the warehouse lender. The warehouse lender, in order to assure repayment by the mortgage banker, often requires the mortgage banker to have a commitment from an investor to purchase funded mortgage loans before the warehouse lender will agree to finance the mortgage banker's mortgage loans. The mortgage loan itself is subject to RESPA, of course, but the mortgage banker and the investor treat the sale of a mortgage loan by the mortgage banker to the investor as a secondary market transaction, which is thereby not subject to RESPA.

A recent decision by the United States District Court for the Eastern District of California has thrown this approach into doubt. In Brewer v. Indymac Bank, 2009 Westlaw 700423 (E.D. Cal), the plaintiffs obtained two mortgage loans from Residential Mortgage Capital (RMC), which "quickly" (the court's terminology, without stating an exact date of sale) sold the loan to Indymac Bank. The loan was brokered to RMC by Dan Brown Mortgage. Nearly three years after the loan was funded, the plaintiffs alleged that RMC devised a scheme with Indymac whereby RMC transferred plaintiffs' mortgage loans to Indymac and received a "secret profit" in the form of a yield spread premium which RMC failed to disclose to the plaintiffs in violation of RESPA, that RMC was the plaintiffs' mortgage broker and thereby owed a fiduciary duty to the plaintiffs which it breached, and that RMC attempted to secure holder in due course status by disguising the table funded transaction as a secondary market transaction designed to circumvent the application of RESPA to the transaction. RMC and Indymac filed a motion for summary judgment, seeking to dismiss the plaintiffs' claims.

The court refused to dismiss the plaintiffs' RESPA-based claims, stating that the plaintiffs' claims were sufficient to withstand a summary judgment motion. The trial court will now decide whether the plaintiffs' claims have any merit.

Based on the description of the facts provided by the court, we believe that Dan Brown Mortgage brokered the loans to RMC. RMC funded the loans, having no intention of functioning as a mortgage broker. RMC then "quickly" sold the loans to Indymac (perhaps pursuant to a commitment to purchase the loans that was in place before the loans were funded), which paid a premium for the loans, a not uncommon occurrence in secondary market transactions. Since the parties viewed this transaction as a run of the mill secondary market transaction, RMC did not disclose its profit to the plaintiffs, who will attempt to convince the court that they have correctly recharacterized the arrangement as a brokered table funding transaction in which Indymac, not RMC, was the true lender.

If the trial court accepts the plaintiffs' description of the transactions here, the ramifications for the secondary market could be enormous. First, the court may have to determine how "quickly" a sale needs to occur after a mortgage loan has funded in order to constitute a table-funded transaction. One day? Two days? A week? Two weeks? Second, and even more significantly, if the court holds that a pre-closing commitment to sell the loan results in the transaction being table funded, it will expose investors to a level of liability that they have not contemplated, and potentially cause havoc in the secondary market.

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

Federal District Court In 11th Circuit Expands Scope Of RESPA Section 8(b)

In a memorandum opinion, a United States District Court for the Northern District of Alabama has held that a real estate broker that charges its customers a percentage based commission and a separate administrative brokerage commission of $149 that is not shared with its sales agents violates Section 8(b) of the Real Estate Settlement Procedures Act (RESPA), because the additional $149 fee was not for services actually performed. JRHBW Realty, Inc. (d/b/a RealtySouth) split its real estate brokerage charge into two components, and showed them on separate lines of the HUD-1 Settlement Statement. The District Court held that the $149 portion of the charge (the administrative brokerage commission) was in essence charged for the same services for which RealtySouth charged its percentage based commission, and therefore was not charged for "services actually performed," and was an unearned fee that violated Section 8(b) of RESPA.

]]> It has for a number of years been HUD's position that a settlement service provider is prohibited by Section 8(b) from charging for a settlement service it did not perform, or from marking up the cost of a settlement service that it did perform. While United States Circuit Courts have split on HUD's interpretation with respect to mark ups (with the 11th Circuit supporting HUD's position), this District Court is the first to hold that a settlement service provider that charges for a service it purportedly did not perform violates Section 8(b).

In light of this decision, real estate brokers in states covered by the 11th Circuit (Alabama, Florida and Georgia), and perhaps elsewhere as well, need to review how they characterize their compensation. Had RealtySouth merely stated that its brokerage charge was X% + $149, and placed the entire charge on one line of the HUD-1 Settlement Statement, the District Court would have been hard pressed to find that the $149 portion of the charge violated RESPA, because courts have long recognized that RESPA is not a price setting statute, and that it is not the role of the courts to determine if a fee charged by a settlement service provider for its settlement services performed is reasonable. Since a real estate broker may charge a percentage based commission or a flat rate for its services, there would seem to be no valid reason to interpret RESPA to prohibit charging a percentage plus a flat fee.

Busby v. JRHBW Realty, Inc. d/b/a Realty South, 609 F.Supp. 2d 1104 (N.D. Ala, 2009)

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

California Passes New Electronic Discovery Act Effective Immediately

On June 29, 2009, Governor Schwarzenegger signed into law California's Electronic Discovery Act, which is effective immediately. All discovery propounded or responded to must now comply with the new law. These rules are very similar to the recent revisions to the Federal Rules of Civil Procedure, and bring California in line with the federal e-discovery standards.

]]> Under the new Act, the party requesting production of electronically stored information (ESI) may specify the format in which it should be produced (e.g., native format, or TIFF, with or without certain metadata, etc.). If no format is specified, the responding party must produce the ESI in either the same format as it is ordinarily kept (likely in native format or an archived/compressed format) or in a "reasonably usable" form. The responding party need only produce the ESI in one form. If a requesting party fails to specify the format of production in its request, and the responding party produces the ESI in a "reasonably usable format," the requesting party cannot then compel a different form of production.

A responding party can resist production of ESI on the grounds that it is not “reasonably accessible.” The factors for determining inaccessibility are undue burden and cost. If a responding party claims that ESI is inaccessible, though, it must still identify the types or categories of sources of ESI that it asserts are not reasonably accessible.

A responding party can resist production of ESI that it claims is not reasonably accessible by moving for a protective order or by opposing or objecting to the subpoena or request. The responding party has the burden of proving that the ESI is not reasonably accessible. Once that burden is met, the burden shifts to the requesting party to show good cause for production despite the fact that the ESI is not reasonably accessible.

If good cause is shown, the court may still order production with conditions, including cost-shifting. The factors that the courts may consider in determining good cause are similar to the federal criteria, including: the existence of more accessible sources; duplicative nature of the discovery sought; the cost of accessing the ESI versus the party’s need for the discovery; the importance of the issues involved; the amount in controversy; and the parties’ resources.

Helping Families Save Their Homes Act of 2009 Imposes New and Uncertain Disclosure Requirements On Buyers and Assignees of Home Loans

On May 20, 2009, President Obama signed into law the Helping Families Save Their Homes Act of 2009. While the primary purposes of the new law include revamping the FHA's Hope for Homeowners program, providing a safe harbor for servicers who modify home loans and giving the Federal Deposit Insurance Corporation and the National Credit Union Association an expanded credit line with the U.S. Treasury, it also imposes a new disclosure obligation under the Truth in Lending Act upon purchasers and assignees of certain home loans that is effective immediately.

]]> Section 404 of the new law amends TILA to require a "creditor" that purchases or takes by assignment a mortgage loan that is secured by the principal dwelling of the consumer to provide the consumer within 30 days after the date on which the sale or assignment occurs a written disclosure notifying the consumer of:

(i) the identity, address and telephone number of the new creditor;
(ii) the date of transfer;
(iii) how to reach an agent or party having authority to act on behalf of the new creditor;
(iv) the location of the place where transfer of ownership of the debt is recorded; and
(v) any other relevant information regarding the new creditor.

There are certain aspects of this new disclosure requirement that are unclear or confusing. First, there is no reasonable way for the purchaser or assignee to determine what "other relevant information" regarding the purchaser or assignee needs to be disclosed. Second, "creditor" is defined in Regulation Z to mean a person that regularly extends consumer credit that is subject to a finance charge or is payable by written agreement in more than four installments and to whom the obligation is initially payable. Since the purchaser or assignee of the home loan will not be the person to whom the obligation is initially payable, it appears that the use of the term "creditor" in Section 404 is misplaced, and it is also unclear whether the "creditor" is intended to be any purchaser or assignee, or only a purchaser or assignee that regularly extends consumer credit that is subject to a finance charge or payable by written agreement in more than four installments.

While Section 404 does not by its terms require new regulations, the Federal Reserve Board has general rulemaking authority under TILA, and a Federal Reserve spokesperson has indicated that the Fed staff will examine the provision and determine whether rules are needed. Rulemaking will likely be necessary to clear up the ambiguities in the new provision, because TILA imposes civil liability on creditors who fail to make the required disclosures. Consumers could also claim that a failure to properly provide the disclosure violates state unfair and deceptive practices laws such as California's, which does not require proof of actual damages in order for injunctive relief or civil penalties to be imposed, but also imposes treble damages in the event that a plaintiff (who could be representing a class) suffers actual damages, potentially subjecting purchasers or assignees of home loans to significant liability.

Since it is unclear when or if the Fed staff will propose rules interpreting the new law, it would seem prudent for all purchasers or assignees of home loans secured by a borrower's principal dwelling to provide the disclosure. While the disclosure is generally simple, the wild card is the requirement that the purchaser or assignee provide "any other relevant information." What might this be? The size of the portfolio of home loans owned by the purchaser or assignee? How likely the purchaser or assignee is to retain ownership of the home loan? Details on litigation to which the purchaser or assignee is subject? There is no way to know, and the relevant information could easily differ from purchaser to purchaser. It would probably be best for each purchaser to discuss this with its counsel.

The Real Estate Settlement Procedures Act and Regulation X have for a number of years required a notice to be provided by both the transferor and transferee servicer when a loan's servicing is transferred. The RESPA disclosure applies to all federally related mortgage loans, not merely loans secured by a borrower's principal dwelling. This means that if servicing is transferred in connection with the purchase or assignment of a home loan secured by the borrower's principal dwelling, both the RESPA disclosure and the new TILA disclosure will be required. If, however, there is no servicing transfer associated with the purchase or assignment of the loan secured by the borrower's principal dwelling, then only the TILA disclosure will be required.

If both the RESPA disclosure and the TILA disclosure are required in connection with a purchase or assignment of a home loan, the purchaser/assignee should consider whether the disclosures should be provided separately or consolidated. The RESPA disclosure must typically be provided within fifteen days after the effective date of the servicing transfer, whereas the TILA disclosure must be provided within thirty days following the sale or assignment; the sale of the loan and the servicing transfer may or may not be concurrent, depending upon the transaction. If the loan sale and servicing transfer are concurrent, and the purchaser/assignee and the new servicer are the same party or affiliated, it would be consumer friendly to consolidate the disclosures. Consolidation can be considered, but may not be practical if the purchaser/assignee and the new servicer are not affiliated.

Finally, in situations where the home loan is being purchased/assigned but servicing is not being transferred, we suggest that the TILA notice state something along the lines of "your loan has been purchased by or assigned to XYZ Corp, but your loan will continue to be serviced by ABC Servicing Company."

If you have questions about any of the foregoing, please call David Sands at (213) 617-5536 or Sherwin Root at (213) 617-5465.

House Financial Services Committee Votes to Suspend Use of New GFE and HUD-1

The House Financial Services Committee yesterday voted to amend the Mortgage Reform and Anti-Predatory Lending Act (the "Act") to require HUD to suspend the implementation of its new Good Faith Estimate and HUD-1 Settlement Statement, and instead to work with the Federal Reserve Board to publish a proposed joint rule with comparable Real Estate Settlement Procedures Act ("RESPA") and Truth in Lending Act ("TILA") disclosures within six months of enactment of the Act, and a final joint rule with comparable RESPA/TILA disclosures within one year of its enactment.

]]> The amendment does not affect other portions of HUD's final RESPA rule, including HUD's new average charge pricing rules that took effect in January 2009 and a clarification that electronic disclosures are permitted under RESPA. In addition, the amendment does not affect the new definition of "required use" that effectively bans builder incentives. HUD separately has delayed the effective date of that provision and has sought comments on whether to withdraw it entirely.

The House Financial Services Committee will continue marking up the Act today. Once the amended Act is approved by the Committee, it will go to the House for a floor vote. The Senate is likely to introduce and pass its own mortgage reform bill (which may or may not include the suspension of the GFE and HUD-1 and the directive to HUD to work with the Federal Reserve Board on disclosures), after which the House and Senate must resolve any differences in a conference.

Authored By:

Sherwin F. Root

(213) 617-5465

sroot@sheppardmullin.com

Lender Liability: Taking Stock in Uncertain Times

Although we have seen little change in the area of lender liability law over the past decade, today's unprecedented slowdown in the global economy is proving to be fertile ground for disputes among lenders, borrowers, guarantors, and other third parties. During the widespread defaults of the 1980s and early 1990s, lenders pursuing remedies were met by a massive upsurge in claims directed at them. During the mid-1980s, California courts expanded the theories under which lenders could be held liable and often awarded substantial damages to plaintiffs. The late 1980s and early 1990s saw a reversal in this trend, where courts limited some of the more far-reaching lender liability theories and reversed a number of high-profile judgments from previous years.

]]> Today, the number of lenders taking enforcement actions is once again on the rise. This will likely result in a corresponding increase in borrowers challenging, and courts probing, lender practices. For example, in response to the exercise of remedies by construction lenders against developers of troubled real estate projects, numerous lender liability claims have been brought by developers - not only to maximize their ultimate recoveries but also to increase leverage in workout negotiations. These claims mostly allege breach of contract and recycle familiar issues such as course of conduct and breach of the covenant of good faith and fair dealing. As the credit crisis spreads in 2009 to various industries and continues to affect all types of lending arrangements, lenders should take care to be aware of the most common lender liability claims (as well as new claims that will begin to evolve), including the following.

Typical Lender Liability Causes of Action

• Breach of Contract. A lender-borrower relationship is a contractual relationship, which may result in a lender being held liable for breaching written, oral, and implied contracts or agreements. Some common breach of contract claims are that a lender failed to (a) lend after a loan commitment became legally binding, (b) extend a loan, honor loan modification terms or forbear from exercising remedies after promising to do so, or (c) take actions required under loan documents or interpret loan documents properly. In breach of contract claims, the courts have considered "course of conduct" between parties as a critical factor in interpreting the language of a contract.

• Breach of the Implied Covenant of Good Faith and Fair Dealing. Borrowers have also used traditional breach of contract claims to piggyback claims based on the evolving theory of breach of the implied covenant of good faith and fair dealing. In jurisdictions recognizing this covenant, lenders have been found liable for (a) refusing to release a deed of trust in an effort to pressure the borrower into paying off another loan and (b) manipulating the appraisal of the borrower's property to trigger a default and deliberately delaying foreclosure to increase the debt through interest accrual, thereby enabling the lender to take the entire collateral. Nonetheless, in most cases the obligation of good faith does not compel a lender to refrain from enforcing express contract terms as written.

• Fraud. Fraud is usually based upon an affirmative misrepresentation. Even where the law imposes no obligation upon a lender to answer an inquiry in the first place, a lender's voluntary response may trigger a duty to disclose additional, pertinent information in a truthful and complete manner. Even where a lender possesses no actual fraudulent intent, constructive fraud may arise if a relationship of confidence and trust exists between borrower and lender and the lender subsequently breaches its duty to the borrower. Additionally, silent fraud may be found if the lender has a duty to speak but chooses to remain silent.

• Economic Duress. In addressing these claims, the courts have drawn a distinction between a lender (a) making inappropriate threats or demands and (b) threatening to do that which it has a legal right to do or refusing to do that which it is not legally required to do. Since it is difficult to assess if a lender has made improper use of legitimate rights or remedies, courts have tended to find liability in cases where the lender's conduct was tainted with some additional fraud or other wrongdoing.

• Tortious Interference with a Contract. Tortious interference with a contract may arise when a lender intentionally induces breach of the borrower's contract with a third party. However, lenders who have interfered with contracts through the bona fide exercise of their rights and remedies have been deemed privileged to do so. Courts have taken varied approaches with regard to whether malice or a purposeful or improper motive are essential elements to this cause of action. Moreover, some courts have allowed lenders to interfere with contracts between borrowers and third parties if the lenders hold equal or superior interests in the subject matter.

• Instrumentality Theory. Under this theory, a lender may expose itself to direct liability to the borrower and third parties where the lender exercises such control over the borrower's day-to-day operations that, in effect, the lender becomes the borrower. Direct liability can also be found where total control of a borrower does not exist, but the lender may be characterized as an agent or principal of the borrower, or the lender's relationship with the borrower is more akin to a partnership or joint venture.

• Breach of Fiduciary Duty. In one recent decision, the court held that the elements to establish a fiduciary relationship between a bank and a debtor are (a) the borrower reposes faith, confidence, and trust in the bank, (b) the borrower is in a position of inequality, dependence, weakness or lack of knowledge, and (c) the bank exercises dominion, control, or influence over the borrower's affairs. Where a fiduciary duty is found, a lender will owe far greater duties to the borrower than those arising under a loan agreement.

• Statutory Violations. With respect to federal tax laws, a lender with sufficient control over a borrower may be liable under the Internal Revenue Code (IRC) for withholding federal taxes. Courts have also held lenders liable under the Racketeer Influenced and Corrupt Organizations Act (RICO) if they engage in activities prohibited thereunder. Also, a significant amount of lender litigation has occurred under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) in relation to lenders exercising a certain degree of control over the day-to-day operational aspects of a borrower's mortgaged property.

The causes of action listed above represent a mere sampling of potential lender liability claims that may be asserted against lenders in today's environment. Additionally, in a syndicated context, lead lenders also have duties to other lenders, the violation of which may expose lead lenders to liability. The foregoing summary is clearly not all-encompassing and only serves as a brief discussion of this vast and growing area of law.

Authored By:

Eugene C. Kim

(213) 617-5404

ekim@sheppardmullin.com

and

Gina Giang

(213) 617-5484

ggiang@sheppardmullin.com

RESPA'S Required Use Rule Delayed

The U.S. Department of Housing and Urban Development (HUD) today announced that it will once again delay the implementation date of the proposed changes in RESPA's new required use definition by 3 months, from April 16th until July 16th, and that HUD intends to seek further public comment on required use practices to determine whether HUD's proposed rule changes are necessary, or whether HUD should withdraw its new required use definition altogether.

]]> The changes to the required use definition, which would have effectively banned the offering of incentives or discounts to a consumer in exchange for the use of a settlement service provider in which the builder had an equity interest, were originally due to take effect in January, but were delayed as a result of lawsuits filed against HUD challenging these changes. While the announcement today will affect the implementation date of the required use definition changes, the timetable of all other changes to RESPA remains unaffected. Click here for a link to the announcement from HUD. For further information on the other changes to RESPA that HUD has proposed, please click here.

Authored By:

David H. Sands

(213) 617-5536

dsands@sheppardmullin.com

and

Sherwin Root

(213) 617-5465

sroot@sheppardmullin.com