Regulatory Settlement of Fraudulent Robo-Signing by Mortgage Servicing Companies
September 30, 2011 by Bierce & Kenerson, P.C.
Like a well-designed software package, BPO services offer the advantages of process uniformity and standardization, scalability, speed to completion, predictability and transparency. When BPO is abused, the advantages can quickly turn into disadvantages of equally grand scale. Such is the tale of “robo-signing” of affidavits of compliance with banking regulations that were based on common practice of non-compliance. This article addresses the settlement by Goldman Sachs with the New York State Department of Financial Services and New York Banking Department in early September 2011. For more click here.
The Business Services of Mortgage Loan Origination Management. The origination of mortgage loans is the first step in the syndication of bundles of mortgage loans for sales to investors, or for retention in a bank’s own loan portfolio of assets. Whether a loan is bundled into a package of collateralized debt obligations (“CDO’s”) or retained as a portfolio asset, the origination process must comply with applicable laws governing Truth in Lending and eligibility for loan guarantees. Such laws include full disclosure of applicable financing terms, consumer protection, due diligence and verification of due execution of the borrower’s promissory note, the mortgage securing the loan, title documents confirming the underlying assets are owned of record in the name of the borrower.
Robo-Signing. The phrase “robo-signing” arose in 2008-2009 when regulators discovered that many BPO service providers in loan origination services falsely provided affidavits of compliance with statutory requirements for bank lending.
The Sub-Prime Debt Crisis. Affidavits of compliance with loan origination requirements are an essential element of any loan origination program for a bank. In the 2000’s, many U.S. banks outsourced the compliance function to service companies. In the U.S. sub-prime mortgage crisis that began in 2008 and continues through at least 2011, the failure of the outsourcing companies to meet a service level of 100% compliance has triggered a tsunami of legal woes:
- Borrowers have alleged in court that they were defrauded (and therefore cannot be foreclosed).
- Investors have sued to rescind their investments in CDO’s because the underlying collateral was fraudulently obtained.
- The CDO market has become unsettled, impairing the free trade and circulation of CDO’s as a source of liquidity in the housing market (and thus a source of sustainability of higher prices).
- Housing prices have collapsed by 30% in many locations.
- Banks are not only prudent to ensure 100% compliance with loan origination laws, but they have been reluctant to lend to qualifying buyers, thereby depressing the housing market and increasing the immobility of homeowners seeking jobs elsewhere.
- Delinquent borrowers have been subjected to loan servicing fees that make it more difficult to repay the loan.
- Non-delinquent borrowers might have an escape from repayment obligations under principles of fraud and rescission, but they cannot escape due to the collapse of “normal” lending markets for residential real estate since 2007.
- Regulators have conducted investigations and sought penalties against banks using robo-signing practices.
Litton Loan Servicing: Goldman Sachs’ Alleged Robo-Signers. In September 2011, the New York State Department of Financial Services and New York Banking Department reached a settlement with Goldman Sachs, as owner of Litton Loan Servicing, as a condition of allowing Goldman to sell Litton to another mortgage servicing company, Ocwen Financial Corp. On September 2, 2011, Ocwen described the deal in its SEC filing:
On September 1, 2011, Ocwen Financial Corporation (“Ocwen”) completed its acquisition of (i) all the outstanding partnership interests of Litton Loan Servicing LP (“Litton”), a subsidiary of The Goldman Sachs Group, Inc. (“Seller”) and provider of servicing and subservicing of primarily non-prime residential mortgage loans (the “Business”), and (ii) certain interest-only servicing strips previously owned by Goldman Sachs & Co., also a subsidiary of Seller. These transactions and related transactions (herein referred to as the “Transaction”) were contemplated by a Purchase Agreement (the “Agreement”) between Ocwen and Seller dated June 5, 2011 which was described in, and filed with, Ocwen’s Current Report on Form 8-K dated June 6, 2011. The Transaction resulted in the acquisition by Ocwen of a servicing portfolio of approximately $38.6 billion in unpaid principal balance of primarily non-prime residential mortgage loans (“UPB”) as of August 23, 2011 and the servicing platform of the Business.
The purchase price for the Transaction was $247.2 million, which was paid in cash by Ocwen at closing. In addition, Ocwen paid $296.4 million to retire a portion of the outstanding debt on an advance facility previously provided by an affiliate of Seller to Litton. To finance the Transaction, Ocwen received a senior secured term loan facility of $575 million with Barclays Capital as lead arranger and also entered into a new facility with the Seller to borrow approximately $2.1 billion against the servicing advances associated with the Business.
The actual purchase price differed from the estimated base purchase price of $263.7 million disclosed in the current report on Form 8-K filed by Ocwen on June 6, 2011 as a result of certain adjustments specified in the Agreement for changes in Litton’s estimated closing date net worth, servicing portfolio UPB and advance balances, among others. The purchase price may be further adjusted as these estimated closing-date measurements are finalized after the closing date.
In connection with the Transactions, Ocwen, Goldman Sachs Bank USA, Litton and the New York State Banking Department have entered into an agreement (the “NY Agreement”) that sets forth certain loan servicing practices and operational requirements. No fines, penalties or other payments were assessed against Ocwen or Litton under the terms of the NY Agreement. We believe the NY Agreement will not have a material impact on our financial statements.
Settlement Terms. The “Agreement on Mortgage Servicing Practices” was consented to by Goldman, Ocwen and Litton. Goldman, which is exiting the mortgage servicing business with the sale of Litton, agreed to adopt these servicing practices if it should ever reenter the servicing industry.
According to the Banking Department, the settlement makes “important changes in the mortgage servicing industry which, as a whole, has been plagued by troublesome and unlawful practices. Those practices include: ‘Robo-signing,’ referring to affidavits in foreclosure proceedings that were falsely executed by servicer staff without personal review of the borrower’s loan documents and were not notarized in accordance with state law; weak internal controls and oversight that compromised the accuracy of foreclosure documents; unfair and improper practices in connection with eligible borrowers’ attempts to obtain modifications of their mortgages or other loss mitigation, including improper denials of loan modifications; and imposition of improper fees by servicers.”
“The Agreement makes the following changes:
- Ends Robo-signing and imposes staffing and training requirements that will prevent Robo-signing.
- Requires servicers to withdraw any pending foreclosure actions in which filed affidavits were Robo-signed or otherwise not accurate.
- Requires servicers to provide a dedicated Single Point of Contact representative for all borrowers seeking loss mitigation or in foreclosure, preventing borrowers from getting the runaround by being passed from one person to another. It also restricts referral of borrowers to foreclosure when they are engaged in pursuing loan modifications or loss mitigation.
- Requires servicers to ensure that any force-placed insurance be reasonably priced in relation to claims incurred, and prohibits force-placing insurance with an affiliated insurer.
- Imposes more rigorous pleading requirements in foreclosure actions to ensure that only parties and entities possessing the legal right to foreclose can sue borrowers.
- For borrowers found to have been wrongfully foreclosed, requires servicers to ensure that their equity in the property is returned, or, if the property was sold, compensate the borrower.
- Imposes new standards on servicers for application of borrowers’ mortgage payments to prevent layering of late fees and other servicer fees and use of suspense accounts in ways that compounded borrower delinquencies and defaults.
- Requires servicers to strengthen oversight of foreclosure counsel and other third party vendors, and imposes new obligations on servicers to conduct regular reviews of foreclosure documents prepared by counsel and to terminate foreclosure attorneys whose document practices are problematic or who are sanctioned by a court.
Notably, the adoption of new “best practices” does not release Litton from future claims or from being investigated in the future.
Lessons Learned. While Goldman might have been negligent in supervising its mortgage loan origination subsidiary, it learned the lesson by divesting the BPO service provider to a larger, more stable BPO service provider. The services provided by Litton had helped feed Goldman’s role as an originator and underwriter of CDO securities that it then packaged and sold into financial markets. The sale of Litton represents an unwinding of this financial chain and should improved the credibility, marketability and liquidity of the CDO markets.
On a broader level, the New York banking settlement underscores the importance of a BPO service provider’s “getting it right the first time.” This means that service supporting regulated businesses should anticipate that their functions will be supervised by regulators even if their function is only a slice of a regulated function. As a result, the risk profile for service providers can be expected to increase where the enterprise customer or the service provider fails to ensure 100% compliance with regulations. Master Services Agreements should be structured to ensure appropriate allocation of liability, together with risk management practices to limit the enterprise customer’s exposure to regulatory investigation and penalties.
Surprisingly, there were no regulatory penalties for Goldman. This may be attributable to good lawyering as well as the fact the “settlement” arose solely in the context of a divestiture, where the purchaser willing purchased a troubled asset.
To learn more about robo-signing click here.
Mortgage Loan Servicing and Other Outsourcing by TARP-Assisted Entities: Criminalization of Contract Fraud under Government Contracts
September 27, 2009 by Bierce & Kenerson, P.C.
Do you know whether you are a subcontractor receiving payments from an entity assisted under the U.S. Troubled Assets Relief Program or the American Recovery and Reinvestment Act of [February] 2009? You should be aware of the criminalization of contract fraud and the protection of whistleblowers denouncing contract fraud in your operations.
Mortgage and other TARP-Related Fraud Claims. The U.S. federal Fraud Enforcement and Recovery Act of 2009 (“FERA”) identified fraud in mortgage origination as a key systemic risk in the financial system. P.L. 111-10, S. 386, 111th Cong., 1st Sess. So it extended the definition of criminal fraud affecting financial institutions to include frauds by mortgage lending businesses that finance or refinance any debt secured by an interest in real estate, including private mortgage companies, so long as their activities “affect interstate or foreign commerce.” And “major fraud against the Government” was extended to include any fraud involving “any grant, contract, subcontract, subsidy, loan, guarantee, insurance or other form of Federal assistance, including through the Troubled Asset Relief Program [“TARP”], an economic stimulus, recovery or rescue plan, provided by the Government, or in the Government’s purchase of any troubled asset as defined in the Emergency Economic Stabilization Act of 2008.” 18 U.S.C. § 1031(a), as amended by FERA.
Budget for Prosecutions. The presumption is that there are criminal frauds in TARP operations. For the initial year, FERA appropriated $265 million for prosecution of such frauds: $75 million for the FBI to investigate mortgage fraud, $50 million for U.S. Attorneys, $35 million for the Department of Justice (allocated $20 million to the Criminal Division and another $15 million for the Civil Division), $5 million for the Tax Division of the Department of Justice, $30 million to combat postal fraud, $30 million for HUD, $20 million for the Secret Service and $20 million for the SEC.
Liability. FERA imposes triple damages liability (plus fines plus the Government’s costs of prosecution) on an extended scope of frauds under the False Claims Act, 31 U.S.C. § 3729(a), as amended. While an element of “knowing” action is involved in such frauds, it may be hard to distinguish between a knowing intention to complete a record that is vague or incomplete with “knowingly making, using or causing to be made a false record or statement to an obligation to pay or transmit money or property to the Government.” If you find you made this mistake, you can cleanse your sins and pay only double damages by confessing in 30 days.
Scienter. So what level of consciousness is required to have criminal “knowledge?” By definition, the terms “knowing” and “knowingly” means that a person “has actual knowledge of the information; [or] acts in deliberate ignorance of the truth or falsity of the information; or acts in reckless disregard of the truth or falsity of the information.” To prove a “knowing” fraud, the prosecutor does not need to prove a specific intent to defraud. FERA, 31 U.S.C. § 3729(b), as amended.
The Government as Customer. Under FERA, anyone who submits a payment request to “a contractor, grantee or other recipient” is subject to a claim of criminal fraud, provided that the money or property to be spent is to be used “on the Government’s behalf or to advance a government program or interest” where the U.S. Government provides “any portion” of the money or property.
Whistleblower Protection. FERA protects “any employee, contractor or agent” from being “discharged, demoted, suspended, threatened, harassed, or in any other manner discriminated against in the terms of conditions of employment because of lawful acts” to stop violations. Such protection includes 200% of back pay plus interest on back pay, special damages and litigation and attorneys’ costs. 31 U.S.C. § 3730(h) as amended.
Impact on Mortgage Loan Servicers. In companion legislation, the “Helping Families Save Their Homes Act of 2009” defines guidelines for “servicers” of mortgage loans who have conflicting duties of serving the interests of investors and the Governmental interest in limiting needless foreclosures that destabilize property values and damage State and local economies. P.L. 111-22, S. 896, 111th Cong., 1st Sess. (2009). “Servicers” provide the services of collecting and paying over to lenders the principal and interest on mortgage loans. Where the loans are bundled and sold as securities (CDO’s, trusts, special purpose entities, participation certificates) or otherwise bundled as a pool of residential mortgage loans, the “servicers” act on behalf each of the lenders across a spectrum of loans.
In the “Helping Families” act, Congress authorized mortgage loan services to “modify mortgage loans and engage in other loss mitigation activities” consistent with Treasury guidelines and defined a “safe harbor” under the Truth in Lending Act (15 U.S.C. § 1472(h), as amended) to do so. In essence, Congress rewrote the mortgage loan servicing contracts.
First, the servicer has some duty to maximize the net present value of the mortgages. In such case, the Helping Families law redefines that duty as not to maximize the value of any single mortgage, but across all mortgage holders combined.
Second, the service is not liable if it implements a “qualified loss mitigation plan” (for residential loan modification or workout, such as by loan sale, real property disposition, trial modification, pre-foreclosure sale, or deed in lieu of foreclosure). This plan needs to meet three criteria: (i) the borrower has defaulted, or default is imminent or reasonably foreseeable, (ii) the borrower occupies the property as the principal residence, and (iii) the servicer determines (under Treasury guidelines) that the loss mitigation plan is “more likely to provide an anticipated recovery on the outstanding principal debt” than the anticipated recovery through foreclosure. By acting under these “safe harbor” principles, the servicer “that is deemed to be acting in the best interests of all investors” is statutorily exempt from liability to any party and is not subject to equitable remedies such as a stay or injunction.
The Perilous “Safe Harbor.” This is not much of a “safe harbor,” since the law is riddled with the tests of “reasonableness” as to the likelihood of the borrower’s future default and as to whether the “loan mitigation” (restructuring or workout) plan is truly in the best interests of the majority of lenders. In mid-September 2009, the Treasury Department issued new “guidance” tax rules that make it easier for distressed property owners to restructure their loans that were bundled into mortgage pools and sold to investors as securities, since earlier “guidance” prevented delinquent commercial developers from talking to servicers about restructuring, and similar “guidance” applied to residential mortgages. (Note: the “Helping Families” law does not apply to commercial mortgage-backed securities, “CMBS”).
Lessons for Service Providers Exercising Business Judgment, such as Loan Servicers. Loan servicing, particularly for bundled or pools of residential mortgages, constitutes a classic outsourcing transaction for well-defined scope of services. While the Real Estate Settlement Procedures Act has traditionally governed loan servicing, the global recession of 2007 and after has placed loan servicers in a unique conflict of interest beyond the usual need to occasionally restructure a loan under pre-recession conditions. The service remains in the challenging position of having to make judgments about whether loan modification will have a higher yield to investors than loan foreclosure. Their job is to identify and work with financially sound borrowers to pursue alternative “loss mitigation” for those who are not. The servicer remains subject to liability for errors in judgment, even if made in good faith. In short, the economics converted the exception into the rule: most loans now need some “loan mitigation.”
In the case of residential and commercial mortgages, the servicers came under Treasury regulations governing defaulting, or imminently defaulting, loans.
Lessons can be learned for those providing “financial and accounting” services, particularly services where mistakes can be seen as possible frauds:
- Using Tools and Business Process Automation to Support Business Judgments. Where a service provider is hired to deliver services that exercise business judgment, the risks of mistake can be reduced by “automating” those business processes that support the exercise of judgment. In the case of mortgage loan servicers, the use of “net present value” computations (which assumes certain market factors such as interest rates and future payment streams) set the framework for deciding whether loans in the loan portfolio would have a higher value if restructured than if foreclosed. In other services, the use of metrics, software tools and other automation techniques help not only with predictive diagnostics, but also with remediation of errors in judgment or service quality. In all services where regulatory compliance is a part of the provider’s role, the policies and procedures manuals should establish decision trees and work flows that meet the regulatory framework.
- Avoiding Fraud Claims. Fraud claims offer a claimant an easy way to pursue an aggressive litigation strategy. Being inherently based on unique facts, each case of “fraud” defies the usual motion by a defendant for summary judgment. By adopting legally compliant workflows and having more than one person responsible for making business judgments, a service provider has a better chance of avoiding fraud liability for “rogue” decisions. While outsourcing is based on well-defined business processes that can be automated or performed by one person, the exercise of business judgment should be a team sport to avoid risks of weak judgment, bad judgment or bad faith (“scienter”).
- Multiple Customers, Conflicting Duties. When the scope of services includes any services that require the exercise of business judgment, prudence or good faith, the service provider should identify how it can legitimately serve the interests of “multiple masters.” The “Helping Families” act gives some leeway by allowing the servicer to act for the general advantage of all “masters,” even though some masters (lenders) will not be getting pari passu equal treatment with the others. Pari passu does not work for multiple customers in a bundle or pooled service.
- Contractual Safe Harbors. Similarly, when the scope of services requires such business judgment or even fiduciary duty, the service provider and enterprise customer should define contractually what considerations and processes should be adopted to reach a “satisfactory” outcome.
- “Change of Control” + “Force Majeure” = Increased Risk. When collateralized debt obligations became unmarketable as “toxic,” the government stepped in and imposed a new framework. Parties to an outsourcing relationship should carefully consider the possibility of such intervention and changes in risk and reward structures by governmental fiat.