State Attorneys General Challenge FDIC’s Madden Fix

State Attorneys General Challenge FDIC’s Madden Fix In early August 2020, several state attorneys general filed suit against the Office of the Comptroller of the Currency (OCC) challenging the OCC’s proposed “Madden Fix.” Notably, while the Federal Deposit Insurance Corporation (FDIC) also issued their own Madden Fix, the agency was not named as a defendant in the initial lawsuit. As such, it is not surprising that a group of attorneys general, many of whom are involved in the suit against the OCC, have now filed a separate lawsuit challenging the FDIC’s Madden Fix. Specifically, on August 20, 2020, the attorneys general of California, Illinois, Minnesota, New Jersey, Massachusetts, New York, North Carolina, and the District of Columbia sued the FDIC in the U.S. District Court for the Northern District of California alleging that the agency’s rule “unlawfully extend[s] federal law in order to preempt state rate caps that would otherwise apply to . . . nonbank entities.”

This lawsuit, like its twin, can be traced back to the Second Circuit Court of Appeals’ decision in Madden v. Midland Funding. In Madden, the Second Circuit cast doubt on the valid-when-made doctrine, a legal concept that, for over a century, has allowed banks to sell, assign, and transfer loans freely. Under the valid-when-made doctrine, a loan is valid when it is created and remains valid when it is sold, even when the purchaser of the loan resides in a jurisdiction where the loan would otherwise be prohibited by state law. Following Madden, the banking and lending industry pushed for a “Madden Fix” by Congress and the prudential bank regulators. In June of this year, the FDIC issued a rule confirming that under section 27 of the Federal Deposit Insurance Act (12 U.S.C. § 1831d), if the amount of interest on a loan is permissible when it is made, it remains permissible despite the sale, assignment, or other transfer of the loan. Lenders saw this rule, along with the OCC’s Madden Fix rule, as a welcome first step in addressing the uncertainty created by Madden.

The lawsuit against the FDIC is largely identical to the suit against the OCC. In particular, the attorneys general contend that the agency’s rule violates the Administrative Procedures Act because the agency purportedly “ignored the potential for regulatory evasion and failed to explain its rejection of evidence contrary to its proposal.” The complaint also attacks the FDIC’s rulemaking as an allegedly impermissible attempt to use its regulatory authority to overturn the Second Circuit’s decision in Madden. There are some differences between this lawsuit and the OCC complaint. For instance, the FDIC suit invokes the language of the Federal Deposit Insurance Act itself, contending that the FDIC, through its rule, violates the act by attempting to extend federal preemption of state interest rate caps under Section 27 of the act to non-FDIC banks.

We are not surprised that the FDIC’s rule is facing a legal challenge, and we anticipate that the agency will vigorously contest these claims. However, this lawsuit adds to the current uncertainty surrounding the emerging fintech industry and bank-partnership model of lending. As we previously suggested in this space, there are practices that banks and non-bank lenders, as well as their fintech partners, can take to mitigate the risks posed by Madden and the True Lender doctrine – a related legal issue that lenders and their partners face during the process of launching innovative bank partnership efforts. Parties should carefully structure partnerships to reduce Madden and True Lender risk. In the meantime, we will continue to monitor this case, as well as the corresponding challenge to the OCC’s Madden Fix.

NYDFS’s New (and Expanded) Servicer Vendor Management Expectations

By Gregory B. Pipes and David Roth on September 15, 2020 Posted in Mortgage Servicing, New York, Vendor Management

NYDFS’s New (and Expanded) Servicer Vendor Management Expectations Originally proposed by the New York Department of Financial Services (NYDFS) in 2019 and constituting what the Mortgage Bankers Association has described as “the first major update to Part 419 since its adoption almost 10 years ago,” the new Part 419 of Title 3 of NYDFS regulations covers a range of significant issues impacting the servicing community. These changes include Section 419.11, which imposes significant vendor management expectations on financial services companies servicing borrowers located in the state of New York. With an effective date of June 15, 2020, time is of the essence for servicers to ensure their vendor management programs and processes meet NYDFS expectations.

Introduction

Over the past decade, most financial service companies have comprehensively overhauled their enterprise vendor management programs to conform with federal regulatory expectations, such as those promulgated by the Office of the Comptroller of the Currency, the Bureau of Consumer Financial Protection (CFPB), and the Federal Deposit Insurance Corporation. As federal regulators have adopted a somewhat less aggressive approach under the current administration, state regulators, particularly NYDFS, have moved to fill the vacuum. While Section 419.11 incorporates aspects of existing federal regulatory guidance, it also includes elements likely not already incorporated into existing servicer vendor management programs. As such, bank counsel as well as impacted subject matter experts within the organization, such as enterprise risk management groups and servicing teams on the business side, must develop and implement a holistic internal review program. Perhaps equally importantly, the organization must preserve appropriate supporting documentation in preparation for the inevitable NYDFS requests for information.

Applicability

Part 419 is intentionally designed to have extremely broad applicability and defines a “servicer” as “a person engaging in the servicing of mortgage loans in this State whether or not registered or required to be registered pursuant to paragraph (b-1) of subdivision two of Banking Law section 590.” The definition of “servicing mortgage loans” is similarly broad and encompasses traditional mortgage servicing activity, reverse mortgage servicers, and entities that directly or indirectly hold mortgage serving rights.

Specific NYDFS Vendor Oversight Expectations

At the outset, it is important for a scoping purpose to understand the nature of the vendors NYDFS expects to be covered under Part 419. Section 419.1 defines “third-party provider” as “any person or entity retained by or on behalf of the servicer, including, but not limited to, foreclosure firms, law firms, foreclosure trustees, and other agents, independent contractors, subsidiaries and affiliates, that provides insurance, foreclosure, bankruptcy, mortgage servicing, including loss mitigation, or other products or services, in connection with the servicing of a mortgage loan.” This is a very broad definition that, as discussed below, occasionally appears to run counter to some of the granular requirements of Part 419.11, which seem designed to apply specifically to legal services provided by traditional default firms.

Part 419.11 opens with the mandate that regulated entities must “adopt and maintain policies and procedures to oversee and manage third-party providers” in accordance with Part 419. Accordingly, even before the subpart numbering begins, regulated entities have their first process-based takeaway: The regulated entity should review each specific, individual mandate in Part 419 and confirm that it is expressly covered in an applicable policy and procedure. This chart or other tracking document should be separately maintained by the regulated entity in case it needs to be provided or used as a roadmap in discussions with NYDFS.

419.11(a) – Subsection (a) itemizes the basic components NYDFS expects to see in an effective oversight program: “qualifications, expertise, capacity, reputation, complaints, information systems, document custody practices, quality assurance plans, financial viability, and compliance with licensing requirements and applicable rules and regulations.” The good news is that each of these elements likely is already covered under vendor management programs designed to satisfy existing federal regulatory requirements.

419.11(b) – An additional component of the 419.11 vendor oversight program is furnished in subsection (b), which states “[a] servicer shall require third-party providers to comply with a servicer’s applicable policies and procedures and applicable New York and federal laws and rules.” There are two elements to this expectation. First, the “shall require” requirement is likely addressed through contractual provisions in the underlying contract between the regulated entity and the vendor. Second, the regulated entity vendor management program will need to include validation of this contractual provision. Again, however, this likely is already part of the regulated entity’s vendor management program.

419.11(c) – It is a foundational principle of financial services vendor management that a regulated entity does not evade liability merely by outsourcing a function to a vendor. Subsection (c) then serves only as a reminder for those regulated entities that might have felt any inclination to forget that rule: “A servicer utilizing third-party providers shall remain responsible for all actions taken by the third-party providers.”

419.11(d) – One of the most significant elements of 491.11 is the disclosure requirement in subsection (d): “A servicer shall clearly and conspicuously disclose to borrowers if it utilizes a third-party provider and shall clearly and conspicuously disclose to borrowers that the servicer remains responsible for all actions taken by third-party providers.” Here is the first provision in 419.11 that may well touch on a gap that currently is not covered by most regulated entity vendor management programs. Unlike the previous subsections discussed, this is not an oversight expectation, but an affirmative disclosure expectation. There is little guidance as of yet on how and where these disclosures must be made, but servicers must act proactively and aggressively to develop a strategy that not only makes these disclosures, but also makes them “clearly and conspicuously.” Note that regulated entities also will be working to make the separate Affiliated Relationship Disclosure under 491.13(a), if applicable, which may be folded into the 491.11(d) disclosure.

419.11(e) – NYDFS further injects itself into the vendor management process in 419.11(e) where it not only identifies the expected frequency of vendor reviews (not less than annually), but also six specific components that must be included in the vendor due diligence. Note that some of the elements set forth, such as preparation of foreclosure and bankruptcy documents (subsection (e)(1)), original document practices (subsection (e)(4)) and sanctions and disciplinary actions (subsection (e)(6)), seem designed with law firms in mind and may not be applicable to more traditional, non-legal vendors. Regardless, those regulated entities with programs that allow for 18-, 24- or 36-month review cycles for low-risk vendors will need to reassess and recalibrate those schedules in order to meet the NYDFS yearly review cycle expectation.

In terms of who performs the review, subsection (e) makes clear that the review may not be performed by representatives of the business: “The review shall be conducted by servicer employees who are separate and independent of employees who prepare foreclosure or bankruptcy affidavits, sworn documents, declarations, or other foreclosure or bankruptcy documents.” While the wording of subsection (e) is somewhat awkward (again it seems to focus on law firms as vendors), the call for independence is not a new requirement; OCC 2013-29, for example, included a requirement for “independent reviews.” Most larger regulated entities will already have their vendor oversight programs performed by independent risk management personnel but, where an entity does not have such a group, it either will need to create one or hire an independent vendor, such as outside counsel, to perform the necessary work.

419.11(f) – Establishment of appropriate and effective lines of communication is captured in the two elements of subsection (f). The first requires the regulated entity to communicate appropriate point of contact information to all its vendors so that they “have appropriate and reliable contact information for servicer employees who possess information relevant to the services provided by the third-party provider.” The second sentence is specifically aimed at law firms and requires regulated entities to “ensure foreclosure and bankruptcy counsel have an appropriate servicer contact to assist in legal proceedings and to facilitate loss mitigation questions on behalf of a borrower.” The creation and maintenance of escalation contacts is not new and, again, this should be an area already covered by regulated entities. However, this provides an opportunity for regulated entities to ensure all contacts are current and properly documented.

419.11(g) – Another precept of effective vendor management is that issues identified during oversight activities be remediated and, where appropriate, that action be taken against the vendor up to and including termination of the vendor. This expectation is captured in subsection (g), which states simply “A servicer shall take appropriate remedial steps if a servicer identifies any problems through the review required by subdivision (e) of this section or otherwise, including terminating its relationship with a third-party provider.” Again, this should already be part of the vendor management program of the regulated entity and should not require significant structure revision of the existing program.

419.11(h) – Finally, subsection (h) returns to the issue of interactions with and oversight of counsel and “those with the authority to fully dispose of the case concerning foreclosure proceedings.” The policies to be developed by the regulated entity must address three points identified by NYDFS. Specifically, they must (1) address “how notice will be provided to foreclosure attorneys and trustees regarding a borrower’s status for consideration of a loss mitigation option and whether the borrower is being evaluated for, or is currently in, a trial or permanent modification;” (2) “ensure that its foreclosure attorneys comply with the requirements of New York Civil Practice Law and Rules Section 3408 with regard to mandatory settlement conferences in residential foreclosure actions;” and (3) “ensure that its foreclosure attorneys comply with all applicable legal requirements including all relevant Administrative Orders of the Chief Administrative Judge of the Courts of New York.” For those regulated entities that manage law firms in a workstream outside of their traditional enterprise risk management programs, the personnel involved in that workstream will need to ensure their program also meets NYDFS requirements.

Conclusion

Any financial services company that believes it is subject to the requirements of Part 419 should ensure that an appropriate working group has been created to review the applicable vendor management requirements of 419.11. Institutional change, particularly at the enterprise vendor management level, does not occur immediately. It will take time to identify the relevant internal stakeholders, review the specific requirements of 419.11, determine the policy, procedure, or operating tool gaps that need to be filled, develop the measures necessary to fill those gaps, and then obtain all necessary operational approvals to implement those measures. With 419.11 now effective, NYDFS is empowered to audit and inspect regulated entities to ensure compliance with existing federal regulatory requirements. Servicers that have not yet finalized their approach to 419.11 are encouraged to do so as soon as possible.

HUD Issues Final Rule on the Fair Housing Act’s Disparate Impact Standard

By Austin Holland and Christopher K. Friedman on September 10, 2020 Posted in Affordable Housing, Banking, Commercial Lending, Compliance, Disparate Impact, Fair Housing, Fair Lending, HUD, HUD Requirements, Mortgage Loan Originators, Tenant Protection

HUD Issues Final Rule on the Fair Housing Act’s Disparate Impact Standard On September 3, 2020, the U.S. Department of Housing and Urban Development (HUD) issued its final rule on the implementation of the Fair Housing Act’s disparate impact standard. The Fair Housing Act (FHA) prohibits discrimination in many housing-related activities on the basis of race, color, religion, sex, disability, familial status, and national origin. For at least the past four decades, HUD and federal courts have read the FHA to prohibit “disparate impact” discrimination, which is conduct that, while not motivated by discriminatory intent, has a discriminatory effect. The final rule becomes effective 30 days from the date of publication in the Federal Register.

The path to the most recent disparate impact final rule has been long and circuitous. In February 2013, HUD codified its long-held view that the FHA bans disparate impact discrimination by issuing a rule entitled Implementation of the Fair Housing Act’s Discriminatory Effects Standard. That rule established a three-part, burden-shifting test to determine whether a housing practice that results in discrimination violates the FHA.

However, in 2015, the U.S. Supreme Court decided Texas Department of Housing and Community Affairs v. Inclusive Communities, in which a non-profit organization claimed that policies of the Texas Department of Housing and Community Affairs regarding the distribution of low-income housing development tax credits resulted in discrimination against African Americans in violation of both 42 U.S.C. § 1983 and the FHA. In Inclusive Communities, the Supreme Court did not rely upon HUD’s 2013 disparate impact, burden-shifting test. Rather, the court undertook its own analysis, resulting in standards that differed from HUD’s rule. While holding that the FHA prohibited disparate impact discrimination, the decision also established several guard rails designed to “protect potential defendants against abusive disparate impact claims.” For instance, the court held that a disparate impact claim cannot be sustained solely by evidence of a statistical disparity. Instead, the court enacted a “robust causality” rule requiring that a plaintiff show that a policy or procedure actually caused the disparity.

Several years after Inclusive Communities, in June 2018, HUD issued an advanced notice of proposed rulemaking purporting to realign its disparate impact regulation to better match the Supreme Court’s holding. In August 2019, HUD issued the proposed rule, very similar to this recently released final rule, that sought to align HUD’s disparate impact analysis with the standards applied by the Supreme Court in Inclusive Communities. After more than two years, HUD finally issued the final rule.

Through its final rule, HUD aims to adopt the disparate impact analysis applied in Inclusive Communities. The final rule creates a new burden-shifting framework for disparate impact claims. Under the rule, a plaintiff must, as a threshold matter, sufficiently plead facts to support that a specific, identifiable policy or practice has a discriminatory effect, and that the challenged policy or practice was “arbitrary, artificial, and unnecessary to achieve a valid interest or legitimate objective.” The plaintiff must further plead that the challenged policy or practice has a disproportionately adverse effect on members of a protected class, that the specific policy or practice is the direct cause of the discriminatory effect (i.e., robust causality), that the alleged disparity caused by the policy or practice is significant, and that there is a direct relation between the injury asserted and the injurious conduct alleged.

If a court finds that a plaintiff sufficiently pleads facts to support each of the requirements above, HUD’s rule then provides the new burden-shifting test, which is summarized as follows:

The plaintiff must first show by a preponderance of the evidence that the challenged policy or practice has a disproportionately adverse effect on members of a protected class, that the specific policy or practice is the direct cause of the discriminatory effect, that the alleged disparity caused by the policy or practice is significant, and that there is a direct relation between the injury asserted and the injurious conduct alleged.
A defendant may then rebut the plaintiff’s allegation that the challenged policy or practice is arbitrary, artificial, and unnecessary by producing evidence showing that the challenged policy or practice advances a valid interest and is therefore not arbitrary, artificial, and unnecessary.
If a defendant rebuts a plaintiff’s assertion under (1) above, the plaintiff must prove by a preponderance of the evidence either that the interest(s) advanced by the defendant are not valid or that a less discriminatory policy or practice exists that would serve the defendant’s identified interest(s) in an equally effective manner without imposing materially greater costs or burdens on the defendant.

In addition, the rule lists a number of defenses that may be used during and after the pleading stage, including that the plaintiff failed to sufficiently plead facts to support the allegations and that the defendant’s policy or practice is reasonably necessary to comply with certain third-party requirements. In administrative cases, HUD will only pursue civil money penalties in a disparate impact case where the defendant has previously been adjudged within the last five years to have violated the FHA.

The language of the final disparate impact rule will not prove too surprising to anyone who has followed the rulemaking process. However, the theory of disparate impact liability has always been, and remains, complicated. Although the final rule appears to reduce the burden on defendants, it also provides additional layers of complexity through the new burden-shifting analysis. Thus, while the proposed rule is likely welcome relief to businesses that are vulnerable to disparate impact claims, it will likely not decrease the number of Fair Housing Act claims and may very well increase the costs to defend the claims.

Federal Agencies to Update Q&As Regarding Flood Insurance

By Heather Howell Wright and Judea S. Davis on September 10, 2020 Posted in Flood Insurance Regulation, Insurance, Natural Disasters

Federal Agencies to Update Q&As Regarding Flood Insurance It has been nine years since the Interagency Questions and Answers Regarding Flood Insurance (Flood Insurance Q&As) have seen any revisions. But that’s all about to change. Under the National Flood Insurance Reform Act of 1994 (Reform Act), the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the National Credit Union Administration (collectively, the Agencies) were required to revise their flood insurance regulations. In compliance with the Reform Act, the Agencies released a joint final rule in 1996. After promulgation of the joint final rule, commenters raised a number of diverse issues regarding the proposed rule. Thus, in 1997, the Agencies issued the Flood Insurance Q&As, which were last revised in 2011, to provide guidance for compliance with the new joint rule.

In late June 2020, the Agencies issued new proposed Q&As to “reorganize, revise, and expand” the guidance due to the substantial changes to flood insurance requirements under the Biggert-Waters Flood Insurance Reform Act of 2012, the 2014 Homeowner Flood Insurance Affordability Act, and the regulations issued to implement these laws. The revisions are meant “[t]o help lenders meet their responsibilities under Federal flood insurance law and to increase public understanding of their flood insurance regulations.” The “significant topics” addressed by the proposed revisions include “major amendments to flood insurance laws with regard to the escrow of flood insurance premiums, the detached structure exemption, and force-placement procedures.” Additionally, the Agencies are also proposing to reorganize the Q&As into “new categories by subject to enhance clarity and understanding for users, and improve efficiencies by making it easier to find information related to technical flood insurance topics.”

Once these new Q&As become final, they will supersede the 2009 and 2011 Q&As and supplement the Agencies’ other guidance or interpretations. The Agencies recently extended the comment period to the proposed Q&A revisions to November 3, 2020. In addition, the Agencies announced they will release another set of proposed Q&As regarding the private flood insurance rule, which provides that regulated lending institutions must accept a private flood insurance policy issued by an insurance company that meets certain conditions and provides flood insurance coverage at least as broad as the coverage provided under a standard flood insurance policy issued under the National Flood Insurance program for the same type of property. Over the next several weeks, we will address several of the proposed changes to the Q&As and the extent to which those changes impact flood insurance compliance of regulated institutions.

CDC Issues Eviction Moratorium, but Will It Survive Legal Challenge?

By R. Aaron Chastain and Grant A. Premo on September 8, 2020 Posted in COVID-19 (Coronavirus), Foreclosing Entities, Foreclosure, Mortgage Servicing, Tenant Protection

CDC Issues Eviction Moratorium, but Will It Survive Legal Challenge? The Centers for Disease Control (CDC) recently issued a sweeping moratorium on most evictions through the end of 2020 as a means to stop the spread of COVID-19, which will go into effect on September 4, 2020. According to government estimates, the order will cover up to 40 million renters nationwide. This unprecedented exercise of power, however, may not withstand the legal challenges that are sure to be brought by landlords and property owners.

The moratorium applies to residential properties nationwide and is available for tenants who earn no more than $99,000 in annual income for an individual or $198,000 for a couple. To halt an eviction, a covered tenant must provide notice to his landlord or the owner of the property under penalty of perjury that he cannot pay the full rent due to substantial loss of income and an eviction would likely render him homeless or force him to move into a “shared living setting.” The order does not provide any financial assistance or other relief for landlords and property owners.

The order is not clear as to whether it bars evictions of persons occupying properties that are owned by a mortgagee or third party after a mortgage is foreclosed. The order expressly states that it does not prohibit foreclosures on home mortgages, but the CDC stops short of saying that the order does not apply to foreclosed properties. The order defines “evict” as applying to an “owner of a residential property, or other person with a legal right to pursue eviction.” The order also refers ambiguously to “housing contracts” and “housing payments,” rather than exclusively dealing in terms of rental or lease agreements and payments. However, the moratorium only applies to “residential property,” which is defined as “any property leased for residential purposes”—arguably not applying to property occupied following foreclosure.

As a basis for this extraordinary exercise of power, the CDC’s order cites section 361 of the Public Health Service Act (PHSA). This provision allows the CDC to make and enforce regulations necessary “to prevent the introduction, transmission, or spread of communicable diseases from foreign countries into the States or possessions, or from one State or possession into any other State or possession.” The CDC’s order also cites 42 CFR § 70.2, a portion of the Code of Federal Regulations that allows the CDC to “take such measures to prevent such spread of the diseases [deemed] reasonably necessary” when the CDC determines that measures taken by any state are insufficient to stop the spread of diseases.

In the past, section 361 has been used to forcibly quarantine a nurse after caring for Ebola patients in Africa, regulate the sale of raw milk, and prohibit the sale of baby turtles, among other things. The CDC’s use of section 361 to prohibit evictions nationwide, however, is a magnitude beyond any previous exercise of power under this law.

When the CDC’s order is invariably challenged in courts, the order might be struck down for various reasons, including that the order violates the Administrative Procedures Act or violates the Constitution’s Takings Clause, Due Process Clause, Commerce Clause, or Contracts Clause. In the meantime, mortgagees proceeding with evictions risk violating the CDC’s order. Stayed tuned for further updates.

Tenth Circuit Agrees with the Fifth Circuit – Private Student Loans May be Dischargeable in Bankruptcy

By Keith S. Anderson, Alexandra Dugan and Christopher L. Hawkins on September 8, 2020 Posted in Bankruptcy, Student Loan Servicing

Tenth Circuit Agrees with the Fifth Circuit – Private Student Loans May be Dischargeable in Bankruptcy The 10^th Circuit has joined several circuit courts holding that private student loans are dischargeable in bankruptcy. In McDaniel v. Navient Solutions, a case of first impression in the 10^th Circuit, the court concluded that an educational loan does not constitute “an obligation to repay funds received as an educational benefit” under Section 523(a)(8)(A)(ii) of the Bankruptcy Code. In Fall 2019, the Fifth Circuit in Crocker v. Navient Solutions similarly held that private educational loans are not statutorily excepted from discharge, absent undue hardship. In other words, they can be discharged like other debt. We previously blogged about the Crocker case, which was widely cited in the McDaniel opinion.

The McDaniel case involved a Chapter 13 filing where the debtors had eleven student loan accounts, owing approximately $200,000. The debtors’ confirmed Chapter 13 plan provided that “[s]tudent loans are to be treated as an unsecured Class Four claim or as follows: deferred until end of plan.” A standard discharge order was issued, and the case was closed. After the discharge, the McDaniels made approximately $37,000 in payments on the loans. The debtors subsequently reopened the bankruptcy case and filed a complaint against Navient seeking (i) a declaratory judgment that their student loans were discharged in bankruptcy and (ii) damages arising from discharge violations. On appeal, the court addressed (1) whether it was res judicata that the student loans were excepted from the discharge based on the confirmed Chapter 13 plan and (2) whether the student loans are non-dischargeable under § 523(a)(8)(A)(ii).

The 10^th Circuit summarily rejected the assertion that the plan established that the student loans were excepted from discharge because the plan contained no explicit statement or determination as to the dischargeability of the student loans. The 10^th Circuit next tackled whether private educational loans are subject to discharge. Section 523(a)(8)(A)(ii) of the Bankruptcy Code provides:

(8) unless excepting such debt from discharge under this paragraph would impose an undue hardship on the debtor and the debtor’s dependents, for –

(A)(i) an educational benefit overpayment or loan made, insured or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or

(ii) an obligation to repay funds received by an educational benefit, scholarship, or stipend; or

(B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual. (emphasis added)

Like the Fifth Circuit in Crocker, the 10^th Circuit emphasized that exceptions to discharge should be interpreted narrowly in favor of the debtor. The court then walked through the various statutory canons to interpret the statute. The 10^th Circuit focused on use of the terms “educational loan” versus “obligation to repay funds received as an educational benefit” and concluded that these clearly mean separate things. The term “educational benefit” is more akin to the other terms in section (A)(ii) (scholarship and stipend) which “signify granting, not borrowing.” In the court’s view, normal speakers of English use the term “benefits” in the context of things such as health benefits, unemployment benefits or retirement benefits to imply a payment, gift or service, not something that needs to be repaid. If section (A)(ii) included repaying private student loans as an “educational benefit,” section (A)(i) would be redundant and contrary to the canon against surplusage. The court concluded that “an obligation to repay funds received as an educational benefit” signifies a conditional grant of funding for education – akin to a stipend and scholarship – as opposed to a loan of funds for education. In other words, “[s]ubsection (A)(ii) was designed to except from discharge grants of money that are tied to service obligations – a category wholly distinct from loans.”

Following the 2005 amendments to Section 523, commentators painted with a broad brush alleging that private student loans were now dischargeable. However, the McDaniel case reflects the growing trend permitting a debtor to discharge certain private student loans. Private student lenders and servicers should take particular note of this case as the latest chapter and prepare for similar challenges.

Agencies Offer Regulatory Assistance in Disaster Affected Areas

By Heather Howell Wright, Judea S. Davis and Austin Holland on September 3, 2020 Posted in Banking, Environmental, Federal Agencies, Insurance, Loan Modification

Agencies Offer Regulatory Assistance in Disaster Affected Areas On the first day of National Preparedness Month, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Conference of State Bank Supervisors issued a joint statement recognizing the impact of Hurricane Laura and the California wildfires on the operations of financial institutions.

Through the joint statement, the agencies announced they will provide the following regulatory assistance:

Lending: The agencies advised that actions taken to alter the terms of existing loans in affected areas “should not be subject to examiner criticism” and that they “will consider the unusual circumstances these institutions face” in supervising any institutions that are affected by these disasters. The agencies recommended that modifications of existing loans should be evaluated individually, considering the circumstances of each borrower and loan, to determine whether such modifications would constitute troubled debt restructurings.
Temporary Facilities: Where regulated institutions face challenges in re-opening facilities after Hurricane Laura and the California wildfires, the agencies “will expedite, as appropriate, any request to operate temporary facilities to provide more convenient availability of services to those affected by these disasters.” Affected institutions may begin the approval process for temporary facilities through a phone call to their primary regulator.
Publishing Requirements: Because damage caused by Hurricane Laura and the California wildfires may affect compliance with notice requirements for branch closings, relocations, and temporary facilities, regulated institutions should contact their primary regulator if they experience difficulties in complying with publishing or notice requirements.
Regulatory Reporting Requirements: Any regulated institution that anticipates difficulty in complying with reporting requirements should contact the institution’s primary regulator to discuss. The agencies advised that they “do not expect to assess penalties or take other supervisory action against institutions that take reasonable and prudent steps to comply with the agencies’ regulatory reporting requirements if those institutions are unable to fully satisfy those requirements because of these disasters.”
Community Reinvestment Act (CRA): Financial institutions may receive CRA consideration for community development loans, investments, or services that revitalize or stabilize a federally designated disaster area.

National Preparedness Month is recognized each September to promote the importance of disaster planning. The theme for September 2020 is “Disasters Don’t Wait. Make Your Plan Today.” Through its website ready.gov, the Federal Emergency Management System provides a number of resources for families and communities, including suggested weekly activities. For example, Week 1 is “Make a Plan,” which encourages friends and family to determine how they will communicate before, during, and after a disaster considering the specific needs of their household.

Over the next several weeks, we will provide additional information about National Preparedness Month and steps financial institutions can take to make their own plan that addresses customer needs and regulatory requirements during disasters.

Third Circuit Holds Bankruptcy Trustee May Relinquish Derivative “Asset Plundering” Causes of Action for Creditors to Pursue

By N. Chris Glenos and Elizabeth R. Brusa on August 31, 2020 Posted in Bankruptcy, Litigation Developments, Secured Creditors

Third Circuit Holds Bankruptcy Trustee May Relinquish Derivative “Asset Plundering” Causes of Action for Creditors to Pursue Recently, in Artesanias Hacienda Real S.A. De C.V. v. North Mill Capital, LLC; Leisawitz Heller, the Third Circuit held that creditors can pursue claims of the bankruptcy estate that have been abandoned by the trustee. Although the plaintiff, Artesanias, had Article III standing to pursue certain claims, because these claims were derivative of harm to a debtor in bankruptcy, they were property of the bankruptcy estate, and only the bankruptcy trustee had “bankruptcy standing” to pursue them. However, the Third Circuit also held that, if the trustee abandoned the claims, Artesanias could again prosecute them.

Background

Artesanias Hacienda Real S.A. de C.V., a judgment creditor of Wilton Armetale, Inc., filed a lawsuit in federal district court against certain parties alleging that they had received fraudulent transfers of Wilton’s assets and otherwise colluded with Wilton to loot Wilton’s assets in frustration of Artesanias’ judgment collection efforts (the “asset-plundering claims”). The parties sued by Artesanias included a law firm that had represented Wilton and a creditor of Wilton that was the beneficiary of allegedly collusive transactions with Wilton.

When Wilton commenced a Chapter 7 bankruptcy case, the asset-plundering claims became property of Wilton’s bankruptcy estate, and Artesanias’ prosecution of the claims became stayed pursuant to ections 362 and 541 of the Bankruptcy Code. However, the Chapter 7 trustee in Wilton’s case ultimately elected to abandon the asset-plundering claims, and Artesanias resumed its prosecution of those claims.

In the meantime, the district court defendants moved to dismiss Artesanias’s asset-plundering claims. However, instead of ruling on the motions to dismiss, the district court referred the suit to the bankruptcy court, finding that the bankruptcy court had “related to” jurisdiction over the matter. The bankruptcy court found that Artesanias lacked standing to prosecute the suit, reasoning that Artesanias’ claims were part of Wilton’s bankruptcy estate, and as such, only the trustee had standing to bring those claims. The court also found that the trustee’s abandonment of the claims did not confer standing on Artesanias to prosecute the claims. On appeal, the district court affirmed the bankruptcy court’s ruling and dismissed the case.

Analysis

“Bankruptcy Standing” Is Distinct from Article III Standing

The Third Circuit noted that, upon the debtor’s filing for bankruptcy, most of the debtor’s assets become property of the debtor’s bankruptcy estate under section 541 of the Bankruptcy Code. A trustee, or a debtor in possession, acts as a representative of the estate under section 323, and in such capacity has the authority to “sue and be sued” on the estate’s behalf. As such, the trustee is the sole party with statutory authority under the Bankruptcy Code to prosecute lawsuits on behalf of the debtor’s bankruptcy estate.

The Third Circuit highlighted that, in the past, it and other circuits had called this statutory authority the trustee’s exclusive “standing” to prosecute claims. However, such “bankruptcy standing” is different from jurisdictional, Article III standing. Adopting the Seventh Circuit’s explanation in , the Third Circuit “recharacterized bankruptcy ‘standing’ as the trustee’s ‘authority’ to act on behalf of the estate.”

Emphasizing this distinction, the Third Circuit held that “a litigant’s ‘standing’ to pursue causes of action that become the estate’s property means its statutory authority under the Bankruptcy Code, not its constitutional standing to invoke the federal judicial power.” Unlike bankruptcy standing, Article III constitutional standing has three elements: “(1) a concrete and particularized injury in fact, (2) that is fairly traceable to the defendant’s conduct, and (3) that a favorable judicial decision would likely redress.” Because the requirements of bankruptcy standing go beyond those three elements, bankruptcy standing does not affect a court’s constitutional jurisdiction.

In light of this conclusion, the Third Circuit held that Artesanias had constitutional, Article III standing to prosecute the asset-plundering claims after Wilton filed for bankruptcy. This was, however, not the end of the Third Circuit’s analysis because, in order to pursue the claims, Artesanias had to also meet the higher bankruptcy standing requirements.

A Bankruptcy Trustee Can Abandon His Bankruptcy Standing over Claims That Are Property of the Estate to a Creditor

Artesanias’ asset-plundering claims were property of Wilton’s bankruptcy estate because they existed at the time Wilton filed for bankruptcy. Additionally, according to the Third Circuit, they were claims Wilton could have brought on its own. At this point, even though Artesanias had Article III standing to bring the claims, only the bankruptcy trustee had “bankruptcy standing” (i.e., authority under the Bankruptcy Code) to pursue them. Only if Artesanias could somehow obtain bankruptcy standing from the trustee could he then prosecute the asset-plundering claims.

Significantly, the Third Circuit noted that a bankruptcy trustee can abandon his statutory authority over claims that are property of the estate. When this occurs, the authority to pursue such claims reverts to the original holder, in this case Artesanias. Holding that “Chapter 7 trustees can abandon asset-plundering claims back to the creditors who had them before the bankruptcy,” the Third Circuit recognized that Artesanias enjoyed authority to again pursue the claims.

Takeaway

Even if a creditor would otherwise have constitutional, Article III standing to bring a claim, if that claim is property of a bankruptcy estate, only the bankruptcy trustee enjoys “bankruptcy standing” (i.e., statutory authority) to pursue it. However, all is not lost for a creditor because a bankruptcy trustee can relinquish his authority back to the creditor to bring such a claim. In that circumstance, as long as the creditor fulfills the elements for Article III standing, the creditor will have jurisdictional authority to prosecute the claim.

After the Waters Recede: The Mortgage Servicer’s Role in Navigating Insurance Claims, Part III

By Heather Howell Wright and Brian R. Epling on August 31, 2020 Posted in Compliance, Foreclosure, Insurance, Vendor Management

In the first part of the series “The Mortgage Servicer’s Role in Navigating Insurance Claims,” we covered assessing property damage and applying insurance proceeds in compliance with the terms of the standard mortgage agreement. In part two, we discussed protecting the mortgagee’s rights under a homeowner property policy. In this final installment, we discuss maximizing coverage under a homeowner property policy.

Part III: Challenging the Denial

After the Waters Recede: The Mortgage Servicer’s Role in Navigating Insurance Claims, Part III Property damages losses attributable to Hurricane Harvey are expected to exceed $25 billion, but only a small portion of these losses will be covered by flood insurance through the National Flood Insurance Program. The standard homeowner policy excludes flood damage, but there are certain water damage losses that may be covered by a standard homeowner policy. Servicers should carefully evaluate property damage and policy language to maximize recovery under a standard homeowner policy.

Across most of the United States, a standard homeowner property policy will cover damage caused by windstorms, such as a tropical storm, hurricane, or tornado. Storms that create excessive winds can cause roof damage or cause trees and other debris to damage the exterior of property, including torn shingles or broken windows. This exterior damage can allow water to enter the property and cause further damage. Rain entering a home as a result of wind damage is not the same as flood damage, and such wind-related water damage should be covered by a standard homeowner policy.

The question that servicers will encounter in Harvey and other storm-related claims is what happens when property is damaged by both rain and flooding. Specifically, what water damage was caused by flood and what water damage was caused by wind-related rain? Insurance coverage in light of these competing causes is complicated by the anti-concurrent causation clause in most homeowner policies. Under this clause, a loss that is caused by a combination of covered causes and excluded causes will not be covered. In many jurisdictions, these clauses are enforceable. In other jurisdictions, however, such clauses are unenforceable by statute or in violation of public policy. Even in those jurisdictions that permit such clauses, if specific damage can be separated by causation, coverage may be available under a standard homeowner policy.

As noted in the second part of this series, a standard mortgage clause creates a separate insurance policy between the insurer and the mortgagee. In addition to the protections provided to the mortgagee previously discussed, the mortgagee provision should give servicers standing to make a property claim under the homeowner policy or to challenge the denial of such a claim. Servicers of loans secured by property that has sustained damage should take the following steps to maximize coverage or challenge the denial of a claim under a property policy:

Describe the property damage carefully: When submitting an insurance claim or challenging a denial, describe property damage as “water damage” rather than damage cause by “flooding.”
Identify evidence that could support a wind damage claim: Such evidence could include blown off shingles, downed trees, shattered windows, or breached doorways.
Contact coverage counsel: Coverage counsel can help evaluate whether to file a claim or challenge the denial of a property claim based on the facts of the damage, the policy language, and the law of the jurisdiction.

Webinar – After the Waters Recede: The Mortgage Servicer’s Role in Navigating Insurance Claims

October 25, 2017
11:30 AM – 12:30 PM CST

Following the recent hurricanes that have damaged many homes beyond repair, borrowers may seek to apply any available insurance proceeds to satisfy the outstanding balance on their loans rather than repair the property. In this webinar, we will discuss precautions servicers should take to ensure they comply with the terms of mortgage agreements and applicable law to protect against potential liability.

After the Waters Recede: The Mortgage Servicer’s Role in Navigating Insurance Claims, Part II

By Heather Howell Wright and Brian R. Epling on August 28, 2020 Posted in Compliance, Foreclosure, Insurance, Vendor Management

In the first part of the series “The Mortgage Servicer’s Role in Navigating Insurance Claims,” we covered assessing the damage in the wake of a natural disaster and applying the proceeds when complying with the terms of mortgage agreements to protect against liability. In part two, we will look into protecting the mortgagee’s rights under a property policy.

Part II: Protecting the Mortgagee’s Rights under a Property Policy

After the Waters Recede: The Mortgage Servicer’s Role in Navigating Insurance Claims, Part II Payment of insurance proceeds to a mortgagee are determined by policy specific language, interpretation of which can vary from one jurisdiction to another. In order to protect the mortgagee’s rights to insurer proceeds, it is important for the servicer to take appropriate steps to ensure those rights are not forfeited.

Property, or hazard, insurance policies are based on the concept of providing protection for an “insurable interest,” which is the insured’s financial interest in the value of the subject of insurance. A property owner has an insurable interest in the insured property, and secured creditors who have loaned money to the property owner also have an insurable interest in the covered property. Most mortgages or deeds of trust require the owner or mortgagor to insure the property and to provide coverage under the property policy to the mortgagee.

A typical mortgagee clause provides as follows: “If a mortgagee is named in this policy, any loss payable under Coverage A or B will be paid to the mortgagee and you, as interests appear.” The “as interests appear” language refers to the mortgagee’s “insurable interest” in the insured property and is generally limited to the amount of the debt secured by the property. The scope of that interest is not specified in the policy. The extent to which the mortgagee is protected by the policy depends on the type of mortgage clause in the policy. Property insurance policies generally contain one of two types of mortgage clauses – an “open mortgage clause,” also called a simple clause, or a “standard mortgage clause,” also called a union clause or New York clause.

Under the open or simple mortgage clause, the mortgagee’s right of recovery under the policy is determined by the acts or negligence of the mortgagor. In essence, under an open mortgage clause, the mortgagee is simply a payee whose right of recovery is no greater than the right of the insured – that is, if the mortgagor is entitled to proceeds under the policy, then the mortgagee is also entitled to proceeds to the extent of its interest. If the mortgagor is not entitled to proceeds (such as in cases of fraud, arson, or vacancy), then the policy is also void as to the mortgagee.

A standard mortgage clause, on the other hand, creates a separate insurance policy between the insurer and the mortgagee so that even if the mortgagor breaches the terms of the policy, that breach will not automatically preclude the mortgagee from recovery under the policy. Since the insurer and mortgagee have a separate policy, the acts of the mortgagor will not automatically determine coverage as to the mortgagee. Because the mortgagee is deemed to have a separate policy with the insurer, however, it is necessary for the mortgagee to satisfy, independently, the conditions of the policy, such as notification regarding changes in ownership or risk. Failure to provide the notice required may void the policy.

One of the conditions of any policy is that the mortgagee take steps to notify the insurer if there is a change in the risk associated with the insured property. Some courts have found that an insurer properly denied coverage under a borrower policy where a foreclosing mortgagee did not provide notice to the insurer of a “change in ownership” or “substantial change in risk.” Some courts have found that foreclosure constitutes a substantial change in risk and have held that provisions voiding a policy for foreclosure or the commencement of foreclosure proceedings are enforceable.

It is also important for a servicer to protect rights to insurance proceeds at the time of the foreclosure sale itself. A lender’s right to recovery under a borrower’s property policy is determined as of the date of the loss and is generally limited to the amount of the unpaid mortgage debt. Because the rights of a mortgagee are determined as of the time of the loss, extinguishment of a mortgage or deed of trust by foreclosure that extinguish the entirety of the debt can result in forfeiture of the mortgagee’s rights to insurance proceeds. Courts appear unanimous across jurisdictions in holding that where the mortgagee bids the full amount of the debt at the foreclosure sale, the mortgagee forfeits any right to the insurance proceeds.

Servicers of loans in default should take the following steps to ensure proper application of these funds:

Advise the insurer when the loan is referred to foreclosure. In order to protect the mortgagee’s rights to potential insurance proceeds in the event of a loss, servicers should advise insurers when the property is referred to foreclosure.
Closely monitor properties scheduled for foreclosure. Aside from regulatory concerns of foreclosure, servicers should ensure that they are protecting the mortgagee’s rights to recovery of insurance proceeds. This may require postponing foreclosure sales if the servicer has reason to believe that there is damage or loss to the property.
Reduce foreclosure bid by the amount of available proceeds. Once a foreclosure sale is scheduled for a property that has sustained an insurable loss, bid instructions should reflect the amount of available insurance proceeds and should deduct those proceeds for the bid amount at sale to protect the mortgagee’s rights to such proceeds.