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The Road Less Travelled: Alternatives to Multi-State Litigation in Response to the American Mortgage Crisis
The mortgage crisis that began in late 2005 debilitated both the American and global economies. It also had major ramifications for large numbers of American homeowners who quickly found themselves owning homes that were worth significantly less than the mortgages used to purchase them. Due to the contemporaneous decline in overall economic conditions and the fact that many homeowners had secured mortgages they were unable to afford, foreclosures rose at an astronomical rate.
Officials at all levels of American government have instituted various measures to “solve” this resulting foreclosure crisis. Some of the most high-profile attempts at forestalling the foreclosure of American homeowners came from the offices of State Attorney Generals. These high-profile actions took the form of multi-state investigations, backed up by the threat of multi-state litigation, of large mortgage brokers and servicers with a national real-estate presence. The investigations made headlines in newspapers around the country and resulted in foreclosure concessions as well as financial windfalls for the States involved. However, high-profile multi-state investigations are not the only, or even perhaps the optimal, response to the foreclosure crisis from a State’s Attorney General.
This paper will explore the approach taken by the Massachusetts’ Attorney General’s Office under the leadership of AG Martha Coakley. Ms. Coakley’s actions against Fremont Investment & Loan were not national news, nor did they result in a headline-grabbing financial settlement. On the other hand, the Fremont lawsuit and a subsequent suit against H&R Block and its subsidiary, Option One Mortgage, accomplished something unique: they prevented foreclosures on the mortgages at issue in the suit while also setting a baseline template for what constituted a “presumptively unfair” mortgage in violation of the Commonwealth’s Unfair and Deceptive Practices Act. Thus, without the fanfare of a national investigation, the Massachusetts Attorney General’s Office obtained relief against particular mortgage brokers while establishing a legal precedent that individuals could use in negotiations or lawsuits with other lenders not party to the AG’s lawsuits. Part I of this paper will outline the mortgage crisis and the resulting tide of foreclosures and then briefly examine the prominent multi-state investigations and negotiations led by State Attorneys General in order to contrast those actions with the lawsuits in Massachusetts. Part II will explore the background of Fremont Investment & Loan and its presence in Massachusetts, before discussing the unique aspects of the Attorney General’s lawsuit and the resulting trial court and Massachusetts Supreme Judicial Court decisions. Part II will then detail the Attorney General’s lawsuit against H&R Block, which seeks to a establish a similar “baseline” of unfair mortgage lending but with respect to racial discrimination rather than financial practices. Part III will then discuss the various advantages and disadvantages of the Massachusetts Attorney General’s approach when compared with multi-state investigations.
Part I— The Foreclosure Crisis and Multi-State Litigation
The United States mortgage crisis has devastated home values across the country. Moreover, it has left numerous Americans unable to meet their mortgage payments. The hardest hit have been those with the types of risky loans that were major contributors to the mortgage crisis: adjustable rate mortgages (ARMs), interest only mortgages and payment option mortgages. Owners of these risk-laden loans are significantly more likely to become delinquent in their mortgage payments and face foreclosure. Moreover, the rising number of foreclosures has created a vicious cycle: mass foreclosures drive investors out of the real estate market, the withdrawal of capital makes it increasingly difficult for distressed mortgage holders to refinance and, thus, more individuals are forced into foreclosure.
State Attorney Generals have sought to break this cycle in a variety of ways, most prominently through well-publicized multi-state investigations. The pursuit of multi-state actions is, perhaps, not surprising: multi-state lawsuits have been a popular “tool” of Attorneys General since the success of the massive tobacco litigation in the 1990s. Moreover, multi-state suits have produced large settlements in a number of predatory lending cases. However, multi-state litigation opens the door for criticism of Attorneys General on a number of levels. Multi-state actions in relation to the mortgage crisis are particularly vulnerable to charges that such settlements usurp legislative power and, perhaps more significantly, that they fail to provide proper levels of relief for individual homeowners.
The most recent and, in some ways, most wide ranging multi-state investigation, is a fifty-state effort to stop mortgage lenders from foreclosing on homes using flawed, or potentially flawed, documentation. The massive investigation made headlines and put the States Attorney Generals at the forefront of “combating” foreclosures.
On the other hand, it isn’t at all clear that the AG’s actions in investigating “robo-signing” and other potentially illegal foreclosure procedures are actually getting to the heart of the foreclosure problem. Before initiating a foreclosure, mortgage brokers are required to produce a sworn affidavit that they own the mortgage in question and that payments are at least six months delinquent. When mortgages are “robo-signed,” brokers never even look at the documents in question—-instead, they pay large numbers of “walk-in hires so inexperienced they barely [know] what a mortgage is” to sign off on the documentation. While such a practice is clearly unethical and perhaps illegal, there is no causal link between mortgage holders whose brokers have “robo-signed” their documentation and mortgage holders who are delinquent on their payments because they were originally sold an unfair and deceptive loan. In other words, it’s not clear that the individuals who were victimized by predatory lending are those who would obtain relief from an injunction against “robo-signed” mortgages. While it is likely that the Attorneys General are simply using the “robo-signing” violations as leverage with which to negotiate wider-ranging concessions from mortgage holders, this is not necessarily a good thing. Such an approach is a clear example of the usurpation of legislative power that leads to criticism of the multi-state investigation: Attorney Generals are not enforcing the law so much as using the law to negotiate procedures and policy for the mortgage industry that might normally be dictated by legislative law-making.
The approach of the Massachusetts Attorney General’s Office stands in stark contrast to this latest multi-state investigation, both in terms of the actions undertaken and the desired results. In particular, Attorney General Coakley took two distinctive steps: 1) she filed a lawsuit and then actually litigated it and 2) she sought, and won, a judicial ruling that would provide relief not just for victims of Fremont Investment & Loan, but for all Massachusetts citizens who had been victimized by predatory mortgage lending.
Part II—- Litigation in Massachusetts
The Commonwealth of Massachusetts was hit hard by the mortgage crisis and subsequent wave of foreclosures. In 2008, the Commonwealth saw 12, 430 foreclosures, the largest number in its history and rate of foreclosures did not decrease significantly from there. Massachusetts’ Attorney General, Martha Coakley, employed a number of approaches to help distressed borrowers in the Commonwealth. Perhaps the most unique of the Attorney General’s efforts was the investigation and subsequent lawsuit against major subprime lender Fremont Investment & Loan.
A. Fremont Investment & Loan
Fremont Investment & Loan was a national mortgage lender based in Brea, California. Fremont maintained a large presence in Massachusetts: they were the second largest subprime lender in the state. Fremont’s mortgage business was heavily reliant on subprime lending: somewhere between fifty and sixty percent of its residential loans were considered subprime. The company specialized in “pulse products,” meaning, as elucidated by a former Fremont employee, that “[i]f a borrower had a pulse, he or she could qualify for one of Fremont’s products.” Nearly forty percent of Fremont’s loans in Massachusetts were stated income loans, in which the borrower was allowed to state his or her income without any form of verification. Once the borrower had stated an occupation and income, Fremont checked the stated income against the average income for the claimed occupation in that geographic area, using the website salary.com.
The result of these lax underwriting practices was predictable: numerous individuals were given loans that they could in no way afford based on falsified occupation and income information. Mortgage brokers such as Fremont, as well as some politicians and journalists, claimed that the true fault in the mortgage morass lay with the borrowers who knowingly falsified their loan applications. Regardless, it is very clear that Fremont encouraged its brokers to sell the riskiest, highest yield mortgages they could by tying brokers’ bonuses directly to the mortgage rates of products they sold. Brokers were paid an additional fee for selling a buyer a mortgage at a rate higher than that buyer qualified for. Fremont also offered its brokers “bounties” for selling mortgages with large pre-payment penalties.
Fremont Investment & Loan was not simply a Massachusetts problem. Before it filed for bankruptcy in 2008, Fremont was one of the five largest subprime mortgage lenders in the country. While Fremont did not, perhaps, have the same level of public visibility as Countrywide, there is no reason Fremont could not have been the target of a similar multi-state investigation. However, the Massachusetts Attorney General’s Office decided to take a very different tack in confronting the issues created by Fremont: they filed a lawsuit and then actually litigated it.
B. The Lawsuit: Commonwealth v. Fremont Investment & Loan
The Attorney General’s lawsuit against Fremont Investment & Loan did not materialize out of thin air. It was an outgrowth of a number of factors, including the mounting rate of foreclosures in Massachusetts, the particular behaviors of Fremont Investment, and the ineffectiveness of negotiated agreements between the company and the Commonwealth.
1. The Lead-Up To the Lawsuit
In early 2007, the Federal Deposit Insurance Corporation (FDIC) alleged that Fremont had engaged in unsound lending practices. The FDIC found that Fremont had been operating “without effective risk management policies and procedures . . . in relation to its subprime mortgage and commercial real estate lending operations.” The FDIC demanded Fremont undertake a number of “corrective actions” including altering its subprime lending policies and devising a plan for restructuring distressed mortgages. Without admitting any sort of wrongdoing, Fremont agreed to comply with the FDIC’s order.
This agreement with the FDIC did not necessarily guarantee immediate relief from foreclosure for borrowers, and this was a significant concern in Massachusetts. By 2007, fully twenty percent of Fremont loans in Massachusetts were in default; the company was responsible for more foreclosures in Boston than any other lender. In response, the Massachusetts Attorney General’s Office negotiated a Term Sheet Agreement with Fremont. Under the Agreement, Fremont would provide the AG’s Office ninety days notice prior to instituting foreclosure proceedings on any residential real estate holding in Massachusetts. During those ninety days, the AG’s Office would review the loans in question and raise any pertinent objections. If the Attorney General did object to a specific loan or loans, Fremont agreed to attempt to negotiate reformation of the objectionable loans. If no reformation or other solution could be reached, Fremont would be allowed to proceed with foreclosure, unless the Attorney General sought to enjoin such an action.
After the Term Sheet Agreement was in place, Fremont submitted one hundred ninety three loans to the Attorney General’s Office. The Attorney General objected to all one hundred and nineteen loans in which the residence in question was owner occupied. Fremont claimed that the Attorney General’s Office was not acting in good faith and terminated the agreement. In response, the Attorney General filed suit against Fremont, seeking to enjoin the lender from foreclosing on any Massachusetts residences without the AG’s consent.
The Attorney General brought suit in Massachusetts Superior Court under the Commonwealth’s Unfair and Deceptive Practices Act, Section 93A. Section 93A is a standard Unfair Practices Act, similar to those found in most states. As in most states, lawsuits brought by the Massachusetts Attorney General under 93A are not uncommon. What made the Attorney General’s lawsuit in Fremont unique was the form of relief requested. The Attorney General actually requested two forms of relief. First, she asked Fremont Investment be enjoined from foreclosing any residential properties in the Commonwealth without the written consent of the AG’s Office. Second, she proposed a “limited preliminary injunction” that would enjoin Fremont from foreclosing on any mortgages that were “Presumptively Unfair.” This alternative proposal for relief, and its implicit creation of “Presumptively Unfair Loans,” is what makes Commonwealth v. Fremont Investment & Loan a unique and interesting legal response to the mortgage crisis.
The Attorney General proposed that a loan should be considered “Presumptively Unfair” if it met certain criteria. Under the proposal, a loan would be presumed unfair if it were an adjustable rate mortgage with “a low introductory rate of three years or less in which either (a) the combined loan-to-value ratio was 90 percent or higher, (b) the loan was approved on a ‘stated income’ basis . . . or© the loan had a prepayment penalty.” If the borrower consented to foreclosure or the property in question was vacant, foreclosure against a presumptively unfair property could proceed.
This argument was unique in a number of respects. First, it sought to enjoin Fremont from foreclosing on mortgages because those mortgages contained certain features, each of which was “expressly permitted by federal and Massachusetts law.” The Attorney General acknowledged this, but termed the legality of the various loan features “irrelevant.” Instead, the Attorney General asked the court to consider Fremont’s “wholesale failure to meaningfully disclose the material terms including, most significantly, the cumulative risk” created by compiling a multitude of high-risk features in a single mortgage. In other words, she claimed that practices that were not barred by law could still violate Section 93A because they were unfair and deceptive in combination.
In support of her position, the Attorney General laid out, in her Complaint and supporting motions, a detailed list of the types of high-risk features common to Fremont loans, including loans of one hundred percent of the value of homes, “piggyback” loans and teaser-based qualifying loans. Of the ninety-eight loans examined by the Attorney General’s Office, every one would produce “payment shock”: once the teaser-rate period ended, interest rates on the loans rose as much as three percent, “with the potential for another 1.5 percent increase hike every six months.”
The trial court adopted the Attorney General’s proposal that certain loans be considered presumptively structurally unfair. After examining the various high-risk features attached to many Fremont loans and detailed in the AG’s complaint, the trial court elucidated its own definition of what constituted a presumptively unfair mortgage. The court held that a loan would be presumed unfair if it met four criteria: 1) the loan was an adjustable rate mortgage with an introductory period of three years or less, 2) the loan had a teaser rate for the introductory period that was at least three percent less than the fully indexed rate (the rate over the lifetime of the loan), 3) the borrower had a debt-to-income ratio of more than fifty percent when calculated against the total value of the loan and 4) the “loan to value ratio [was] 100 percent” or the loan had a significant prepayment penalty. The court then provided the requested injunction, which required Fremont to give advance notice to the AG’s office of any potential foreclosure and, for any mortgage that met the four criteria for unfairness, to make good faith efforts to reform or restructure the loan. If reformation proved impossible, Fremont was required to obtain the AG’s permission to proceed with the foreclosure. Subsequently, the court modified the injunction to prevent Fremont from selling any of its residential loans unless the purchaser agreed to the terms imposed by the injunction.
Fremont immediately appealed the Superior Court’s ruling. After the Court of Appeal declined to reverse, the Massachusetts Supreme Judicial Court granted Fremont’s request for direct review. On appeal, Fremont’s “basic contention” was that the trial court improperly applied unfairness standards in a retroactive manner: in other words, Fremont’s loans were not unfair at the time they were made; they only appeared unfair in retrospect. The Supreme Judicial Court rejected this argument, primarily because it found that, in creating loans with all four criteria singled out by the trial court, Fremont knew that they had created a situation that virtually “guarantee[d] that the borrower would be unable to pay and default would follow. . . .” The Court found that the injunction properly served the public interest and affirmed.
In 2009, the Attorney General reached a settlement agreement with Fremont Investment. Fremont agreed that the terms of the preliminary injunction, including the definition of what constituted unfair loans, would become permanent.
4. The Aftermath— New Regulations & Lawsuits
The Attorney General subsequently issued a series of regulations that, inter alia, codified the Fremont criteria for defining a presumptively unfair loan. The Fremont decision then provided the basis for a lawsuit against H&R Block and its subsidiary, Option One Mortgage, that sought to build on the foundation established in Fremont. H&R Block contains many of the same allegations as those leveled against Fremont Investment & Loan. Under the precedent of Fremont, the defendants had little recourse other than to make Constitutional claims: the defendants argued that the Attorney General’s interpretation of Mass. Gen. Laws c. 93A, as applied in Fremont, was so broad as to be unconstitutionally vague. The trial court rejected this contention in denying the defendants’ motion to dismiss and granting the Attorney General a preliminary injunction.
H&R Block is particularly noteworthy for the inclusion of a new charge: violation of the Massachusetts Anti-Discrimination Act. The Attorney General’s Office claimed that the defendants had violated Section 4(3B) of the Act, which prohibits racial discrimination in the granting of mortgage loans. In her Complaint, the Attorney General outlined the defendant’s discriminatory marketing and mortgage practices. The marketing practices included distributing to its brokers materials urging sales of subprime mortgages to racial minorities because those individuals had limited financing opportunities and encouraging mortgage brokers to partner with real estate brokers of the same race as the targeted minority borrowers. The discriminatory mortgage practices resulted in a “substantial disparity” in fees charged to minority borrowers when compared to Caucasian borrowers. For example, a minority borrower paid roughly $3,500 more in fees than did a white borrower with a lower credit score on similar mortgages.
The Attorney General did not, however, simply allege individual instances of discrimination. Instead, she charged the defendants with systemic discrimination, defined as “the maintenance of a general practice or policy aimed at members of a protected class.” The argument provided two benefits: 1) it could be applied to any minority borrowers who had done business with the defendants and 2) it allowed 151B—4(3B) discrimination claims to be brought after the statute of limitations had expired. The second benefit is particularly significant: Massachusetts law provides that housing-related lawsuits must be brought within a year of the occurrence of the alleged unlawful act unless there is a showing of systemic discrimination. While the H&R Block litigation is still ongoing, the trial court looked favorably on this systemic discrimination argument in granting the Attorney General’s requested preliminary injunction and denying the defendants’ motion to dismiss.
Part III — Evaluating the Massachusetts Approach
The Massachusetts Attorney General’s approach to helping distressed homeowners in the Commonwealth was unique both in its execution and in the result achieved. While it is impossible to say whether the AG’s litigation-based approach is superior to other techniques, such as the multi-state investigation and negotiation, it seems clear that Fremont and H&R Block create both benefits and drawbacks distinct from those achieved in multi-state actions.
1. Benefits of Litigation-Based Approach to the Foreclosure Crisis
The Massachusetts Attorney General’s litigation in Fremont and H&R Block provided both “primary” benefits—those felt directly by homeowners in the Commonwealth-and “secondary” benefits—those that indirectly assisted homeowners or improved the Commonwealth generally. The “primary” benefits secured by AG Coakley are similar to those secured in a number of the multi-state negotiations: a slowdown of the foreclosure process and financial remuneration for the states. Obviously, both factors are significant for the Commonwealth and for individual homeowners.
However, the most important part of the Attorney General’s lawsuit and the subsequent decision in Fremont was a “secondary” benefit: the creation of a baseline for what constituted an unfair loan in violation of Massachusetts law. The Fremont holding extends beyond Fremont Investment & Loan itself—it is potentially applicable to all loans made in the Commonwealth, regardless of the lender. On the other hand, a multi-state settlement such as that made with Countrywide is applicable only to loans made or held by Countrywide. Thus, while some Attorney Generals might hope that Countrywide could provide a “template” for future negotiations, the Fremont case established actual judicial precedent that would control all Massachusetts residential real estate actions from that point forward. Fremont provided individuals saddled with unfair loans a starting point from which to renegotiate their mortgages in a manner that suited their individual needs. The Fremont decision also incentivized private attorneys to take on clients with “presumptively unfair” mortgages—because the burden of proving unfairness was shifted to the defendants, attorneys with limited resources had the ability to take on large corporations on behalf of individual clients. Further, by enhancing individuals’ bargaining position, Fremont may allow homeowners to secure relief that meets their particular needs. This is not always the case with wide-ranging multi-state settlements.
The “secondary” benefits of the H&R Block case could prove similarly effective. In particular, the Attorney General accomplished two things: 1) she used her office’s resources to investigate the racially discriminatory practices of certain mortgage lenders, thereby providing a factual template for individuals to use in the future and 2) she used the compiled data on race and lending to make an effective charge of systematic discrimination. As with the Fremont case, these benefits are important in the manner in which they incentivize individual action and, thus, offer the potential for more personalized and effective mortgage reformations. In particular, the Attorney General’s convincing argument that mortgage lenders engaged in systemic racial discrimination opened the door for individuals to bring discrimination suits that would have otherwise been barred by the statute of limitations. While each of these benefits is significant, a litigation-based approach to confronting the mortgage crisis has certain drawbacks when compared with multi-state negotiation.
2. Drawbacks to Litigation Based Approach to the Foreclosure Crisis
The major drawbacks to a Fremont-style approach are issues related to the nature of litigation itself. Perhaps the clearest problem is that litigation entails risk. In a negotiation, an Attorney General knows exactly what deal she is receiving. By actually litigating, the AG runs the risk of securing an unfavorable decision, which would potentially hamper both future litigation and future negotiations. On the other hand, this risk is mitigated by the very nature of the mortgage crisis. Companies like Fremont Investment & Loan were clearly “bad actors”—-they made reckless loans with little regard for even basic underwriting practices. An Attorney General bringing an action against companies such as these in a state trial court is likely in an advantageous position before the trial even begins.
A second potential drawback is the feasibility of litigation. Not every Attorney General’s Office will have sufficient resources or trial experience to successfully litigate against large corporate entities. For states lacking in resources, joining a multi-state investigation may be the only reasonable option. But for states like Massachusetts, it is important to recognize that litigation does not foreclose other options such as regulation and negotiation—-in fact, successful litigation may improve a state’s position in future negotiations.
The Fremont and H&R Block are unique in that they represent an uncommon approach to the foreclosure crisis and they achieved uncommon, and highly beneficial, results. The lawsuits provided direct relief against particular lenders while establishing a standard for unfairness and racial discrimination in lending that applied to all lenders. They created an opportunity for individual action against large corporations as well as improving the Attorney General’s position in future negotiations with other lenders. They did so not through negotiation and quasi-legislative action, but through the most traditional approach an Attorney General can take in combating unfairness: actual litigation.
It is impossible to state whether one approach to America’s foreclosure crisis is clearly superior to another—-each action has its own set of benefits and drawbacks and there is no obvious solution for the millions of American homeowners “underwater” on their mortgages. However, the Fremont and H&R Block lawsuits are strong reminders that the option of actual litigation is one that State Attorneys General should consider as a part of their response to the crisis. While actual litigation is, perhaps, “the road less travelled” for the modern Attorney General facing down the foreclosure crisis, it is a road that more Attorneys General should consider exploring.
May 21, 2013
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