CMLA Webinar Presentation: Third Party Loss Mitigation

Strategies and Tactics for Lenders

Presented by James Brody, Esq.American Mortgage Law Group, P.C.

75 Rowland Way, Ste. 350, Novato, CA 94945Telephone: (415) 878-0030

Email: JBrody@americanmlg.com info@americanmlg.com

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Overview

• This webinar explores what avenues of third party recovery exist and what tips and strategies a lender should be aware of in contemplating efforts to recover losses attributable to third party actions. – Legal basis for pursuing different third party entities: does the

lender have valid claims?– Costs vs. rewards: the lender should balance the fees/time of

pursing the third parties vs. the likelihood of success.– Balance of interest: the pursuit of third parties needs to be

balanced against defending claims.

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The Recovery of Losses by Lenders through the Pursuit of Third Parties

• Lenders have suffered staggering losses in the past few years resulting from repurchase obligations and also borrowers’ suits. These losses often times stem from the actions and/or inactions of third parties, including: borrowers, brokers, appraisers, settlement agents, title companies etc.

• Often times, lenders will find themselves saddled with loans they had been forced to repurchase and/or suffer losses in connection with loans they originated and sold on the secondary market (e.g., occupancy misrepresentations, undisclosed debts, appraisal misrepresentations, falsified gift letters, etc.)

• Sometimes these events will trigger an audit by HUD or other licensing authority, resulting in compliance fees, fines, penalties, and, in some cases, decertification.

• Losses attributable to the actions and/or inactions of third parties have been accumulating on lenders’ balance sheets for years. Lenders have been forced to analyze how and against whom they may seek redress from.

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Factors to Consider in Pursuing Third Parties: The Cost v. Benefit Analysis

• What are ALL the potential costs of pursuing a third party (e.g., the investment of time, money and resources).

• Cost of writing letters/making claims • Litigation (fees/time vs. likelihood/extent of recovery)• ADR• Regulatory Compliance

• How much is at stake? Average losses are around 33% of the loan balance, including fees and interest. If the potential amount recovered does not exceed the costs of pursuing the third party, the lender should rethink their strategy.

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Factors to Consider in Pursuing Third Parties: Picking the Right File to Pursue

•Picking Your Target: The lender should first identify/target the responsible third parties based on the underlying facts (i.e., appraisers, brokers, borrowers, etc.)

•Is the Third Party Still in Existence? Before beginning pursuit of a third party (i.e., before committing substantial resources) the lender should do its due diligence by checking websites, corporate and licensing documents to make sure the entity is not defunct.

• Gathering the Paperwork: The lender should identify and gather essential documents, including: loan application, settlement statement, audit report, repurchase demand and damages calculation.

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Range of Possible Third Parties to Pursue

• Appraiser • Borrower• Broker• Errors & Omissions • Mortgage Insurance • Other Insurance Policies• Seller• Servicer • Settlement Agent• Title Insurance Company

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Pursuing an Appraiser

Key Issues•More than a 10% inflation of value•Not in compliance with USPAP requirements •Statute of limitations varies by state (lender should be aware/advised of them by an attorney)•Does privity of contract exist? Was the appraisal ordered by the broker or lender? •For self-employed appraisers, consider piercing the corporate veil in case of alter-egoPossible Causes of Action •Professional Negligence •Fraud•Conspiracy •Breach of Contract

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Pursuing an Appraiser

• Lenders should first send a Notice to appraiser advising him/her of the underlying allegations and requesting a copy of the E&O policy.

• An attorney should draft the Notice on the Lender’s behalf to make sure the necessary language is contained therein.

• The Lender should be aware that the arguments it uses to defend the appraisal in a repurchase claim might contradict with its pursuit of the appraiser.

• An attorney should order a retrospective review appraisal in case it is negative, so that it will be protected from discovery by attorney work-product privilege.

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Pursuing a Broker

• In the event there is a broker in the transaction, look to the terms of the broker agreement to see if there are any grounds to pursue the broker.

• The agreement pursuant to which the loan was brokered frequently includes provisions allowing for recourse if the lender is required to repurchase the loan from its investors (i.e., failure to meet investor guidelines) or if the loan involved a defect that would render it ineligible for sale on the secondary market.

• It may also include a strict liability/misrepresentation by any party clause (i.e., no fault) that the lender should look out for.

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Pursuing a Broker

• The lender and, preferably, its legal counsel should review the broker contract for provisions triggering its right to seek recovery against the broker.

• If such provisions exist in the contract, the lender should make a formal demand (often the contract will prescribe the form, timing, and service of notice).

• In the event the broker does not acknowledge and perform its obligations to do so, and assuming all other contractual predicates are met, the lender may bring an action against the broker for such causes of action including, but not limited to as follows: breach of contract, professional negligence, negligent supervision and/or conspiracy to commit fraud.

• As before, knowing the applicable statute of limitations and the broker’s financial wherewithal is key should a lender decide to bring a claim.

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Pursuing a Broker

Sample Recommended Broker Agreement Language:

“Broker shall not submit any Mortgage Application or other

Mortgage Loan Documentation containing false/misrepresented information”;

“Broker shall repurchase any Mortgage Loan containing the false/misrepresented information”;

“[Lender] sells its loans to secondary market investors after closing and is relying on the representations/warranties made by Broker”;

“Any Mortgage Loan submitted by [Broker] will comply with all applicable federal, state and local laws etc.”

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Pursuing a Broker

Broker Bonds• Some states require the purchase of a Broker Bond.• Broker Bonds call for recovery in case of fraud by the

broker. • Lenders should determine whether and to what extent

they can collect in any givens state and act accordingly to mitigate their damages.

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Pursuing a Broker

Broker Bonds: Sample State Required Coverages:

State Amount Required Who Can Claim?

Arizona $75,000 Anyone with a cause of action

Georgia $50,000 Anyone with a cause of action

Illinois $100,000 Comm. of Dept. of Finance Only

Indiana $50,000 Any damaged individual or State

Kentucky $50,000 Any person with a cause of action

New Jersey $150,000 New Jersey Dept. of Banking Only

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Pursing a Borrower

• Lender should evaluate whether the borrower has any assets against which it could levy a judgment.

• Lender should also determine whether the borrower has declared bankruptcy or (in the case of fraud) whether they have been implicated either civilly or criminally in other fraudulent schemes.

• Lender should get a borrower’s cooperation and have them sign an affidavit against other parties.

• Refinancing or selling the collateral is another way of reducing losses; indeed, the repurchase demand may also disappear as a result. But because repurchase demands often times occur after defaults, the chances of this occurring have diminished.

• Lender may also contact the authorities in cases of fraud (against any third party) but should be aware of the pitfalls, including:

– Proving the defendant’s guilt in court (gathering witnesses, etc.)– In case of defendant’s arrest, the chances of recovery are diminished (i.e., getting restitution; thus, a lender

should attempt other means of recovery before contacting authorities). – The authorities are not well equipped to deal with mortgage fraud cases.– Entities such as the FBI are not interested in dealing with cases that are for less than $1 million dollars.

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Pursing the Settlement Agent

Key Issues • Misrepresentation of Down Payment• Property Flipping – Seller Not on Title• Simultaneous Transactions for Same Borrower• Settlement Agent Did Not Follow Closing Instructions

Causes of Action • Breach of Contract (Closing Protection Letter)• Breach of Fiduciary Duty • Conspiracy to Commit Fraud

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Pursing the Settlement Agent

• Do you have standing to pursue the settlement agent personally or through the CPL? – Request an assignment from the investor of the right to pursue the settlement agent. – Request the title company or settlement agent to pay the investor directly.

• Difference between CPL and Title Policies: CPLs provide a lender with money for malfeasance; title policies provide a lender with the title.

• Determine the scope of coverage: – Failure of the settlement agent to comply with the written closing instructions to the extent

that they relate to (1) validity and priority of the title; (2) the obtaining of any documents requested by the lender; or (3) the collection and payments of funds due to the lender.

– Failure or dishonesty of the settlement agent in handling the funds or documents in connection with the closing and/or escrow.

• Look at time limitations on different CPLs: – CPLs used to be “prompt”; now CPLs require notification of any wrongdoing 90 days from

discovery or 1 year from loan origination. • The title company should also be put on notice of the potential CPL claim as soon as a potential

breach is discovered.• If the CPL was not issued in conjunction with the subject loan, recovery may be pursued through

the closing agent directly for the failure to adhere to the closing instructions and/or potential fraud/dishonesty.

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Pursuing a Title Claim

When should you file a title claim?

• When there is a title defect (i.e., mechanic’s lien, or encroachment);

• When there is fraud (i.e., a flip transaction).

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Pursuing a Title Claim

What should you look out for when dealing with a title insurance company?

• Once they rectify the defect, they will generally not indemnify for any losses a lender might have incurred in relation to its repurchase claim;

• Even if they agree to indemnify, the lender will need to show proof of loss which could be difficult if the loan is part of a global settlement.

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Pursing an E&O Claim

• Before filing a claim against a professional entity, the lender should immediately ascertain whether and what kind of active insurance coverage may apply and what type of claim(s) will trigger coverage.

• Almost invariably, tapping an insurance policy represents the best chance for the lender to recover losses attributable to actionable negligence and/or fraud.

• A lender will maximize its chance of recovery by alleging both fraud and negligence in its E&O claim:– Most policies cover negligence, not fraud; BUT– The insured will want its carrier to find negligence so that it will not be

pursued personally.

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Pursuing the Seller

Key Issues • Additional Transactions• No Direct Relationship

Causes of Action • Unjust Enrichment / Constructive Trust• Conspiracy to Commit Fraud

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Pursing an E&O Claim

• An insurance policy may often remain in place several months after a brokerage has gone defunct; in which case a lender must interpose a notice of legal complaint prior to the lapsing of the policy.

• Similarly, an individuals appraiser’s E&O policy may even follow him; thereby surviving the end of the appraisal company that he was associated with.

• Factors to consider in filing a claim with your own E&O carrier:– Most do not cover the loss incurred in repurchasing a loan.– Many do cover part of authorized attorney fees and expenses

spent on defending the repurchase claims.– Some might provide employee dishonesty coverage.

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Other Insurance Policies Mortgage Bankers Should Look to for Their Recovery Options

1) Fidelity Bonds – Fidelity coverage for loss from employee dishonesty as well as from any closing agent; can also cover third party originators and/or servicing contractors.

2) Mortgage Impairment Insurance - Mortgage interest portion protects mortgagee or owner interest in under-insured or un-insured properties against physical damage losses from "required" perils.

3) Privacy Indemnity - Provides protection in the event that customers’ personally identifiable non-public information is lost, stolen or the insured suffers an unauthorized disclosure. This coverage also offers protection and assistance to comply with breach notification laws in the event of a network security breach.

4) Professional Liability - Covers a firm's legal liability for errors and omissions made in professional roles such as loan origination, underwriting, processing, marketing, closing, warehousing and servicing.

5) Directors and Officers Policy - Protects individuals against suits arising from their role as a director or officer of the firm.

6) Mortgage Insurance (MI) - Does not cover loans where fraud is found.

7) Mortgage Fraud (Reps and Warranties) Insurance – Fills the gap in MI insurance for fraud coverage.

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Pursing the Servicer

• Analyzing the Servicing Contract is Key.• Look to the allocation of fault and the

representations and warranties in the Contract.• Specifically, have your attorney analyze:

– Language regarding servicer’s performance of its obligations; and

– Indemnification language in determining if Servicer is worth pursuing.

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Key Issues of Third Party Recovery: Fraudulent Acts

• Lenders should be aware of the peculiar challenges they face in recovering against third parties in the event of fraud.

• For instance, tapping into insurance coverage for losses arising out or attributable to fraudulent activities are almost always excluded from insurance coverage.

• Accordingly, a lender is often barred from recovery of losses arising out of a broker’s breach of contract under the policy, unless that breach is shown to have been inadvertent and/or negligent.

• These exclusions pose a conundrum to lenders seeking to recoup losses that may even be arguably attributable to fraud.

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The Key Issues of Third Party Recovery: Fraudulent Acts

• On the one hand, a lender may often plead fraud, fraudulent misrepresentation, breach of fiduciary duty and even civil conspiracy counts against a broker (for example) which defrauded it.

• Although these counts are more difficult to prove than garden variety-counts for breach of contract or negligence, a favorable computation, and even a trebling of damages is available to the plaintiff who is able to prove these, let alone the accompanying vindication.

BUT….

• A lender advancing these claims may well plead itself out of coverage under any applicable insurance policies which it could otherwise use to recoup its losses.

•In this vein, a lender must decide early on (and after consulting an attorney) what its goals are. Does it seek to make an example of the malfeasant, and perhaps forgo monetary recovery? Or is it willing to tone down its allegations in order to ensure coverage is triggered?

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Concluding Thoughts

• A lender who decides to pursue a third party to recoup its losses is essentially making an investment in the form of: time, staff fees, attorney fees and possible litigation costs.

• A lender must be prepared to endure a not-so-smooth recovery process that may include: borrowers being insolvent or moving several times since the closing of the loan; brokers shutting down one business only to resurface elsewhere or the lack of an insurance policy to tap into.

• However, good legal counsel and diligent investigation can focus a lender’s efforts upon the most promising endeavors while keeping costs down and focusing on the issues which present the best options for a speedy recovery.

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THANK YOU!