Force-place Insurance and RESPA Section 8

QUESTION
Our procedures to implement force-place insurance has come under some scrutiny by our regulator. Specifically, they think we are overcharging for the insurance. 

Our position is that we may charge in excess of the cost. However, they believe that Section 8 of RESPA is being violated. We need some clarification, so we are turning to you. 

Does charging in excess of the force-place insurance cause a violation of RESPA Section 8?

ANSWER
I am going to answer by taking you through a bit of history, wending our way into definitions, sashaying past regulatory requirements, traipsing into a seemingly dispositive doctrine, wandering over to illustrative litigation, and arriving at an observation. Enjoy the journey!

Let’s start with the uniform security instruments published by Fannie Mae and Freddie Mac, which most mortgage lenders use or adapt for their own use, state the lender’s right to “force-place” hazard insurance coverage:

Borrower shall keep the improvements now existing or hereafter erected on the Property insured against loss by fire, hazards included within the term “extended coverage,” and any other hazards including, but not limited to, earthquakes and floods, for which Lender requires insurance. This insurance shall be maintained in the amounts (including deductible levels) and for the periods that Lender requires. What Lender requires pursuant to the preceding sentences can change during the term of the Loan. The insurance carrier providing the insurance shall be chosen by Borrower subject to Lender’s right to disapprove Borrower’s choice, which right shall not be exercised unreasonably … If Borrower fails to maintain any of the coverages described above, Lender may obtain insurance coverage, at Lender’s option and Borrower’s expense. [My emphasis.]

The last sentence is a right that has a rather nasty reputation because there has been much consternation about the cost of force-placed insurance occasionally being many times as expensive as policies bought by borrowers on the retail market. Thus, herein lies the nub of the issue: allegations spring from the notion that one reason replacement insurance is so expensive is that the force-placed insurer handsomely compensates the lender and might be closely related to the lender. Hence, the less than thrilling whiff of Section 8 fumes fills the air!

In fact, that nasty reputation led Congress to include Section 1463(a) in the Dodd-Frank Act, which amended the Real Estate Settlement Procedures Act (RESPA) to add three subsections affecting force-placed insurance and loan servicers’ duties.

Section 8 of RESPA, which targets kickbacks and referral fees that unnecessarily increase settlement services costs, doesn’t reach force-placed insurance abuses because forced placement typically occurs a year or more into the timeline of a mortgage loan. And, because the insurance is force-placed after loan origination, the insurance is not a “settlement service” reached by Section 8. As a result, Section 1463(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act amended RESPA Section 6(k) and (l) to prohibit a servicer from obtaining force-placed insurance unless a reasonable basis exists to believe the borrower has failed to comply with the loan contract’s requirements to obtain property insurance. This prohibition did not take effect until the CFPB adopted regulations as part of its January 2013 Regulation X Servicing Rule, effective January 10, 2014.

RESPA defines the term “force-placed insurance” to mean hazard insurance coverage obtained by a servicer of a federally related mortgage loan when the borrower has failed to maintain or renew hazard insurance on the security property as required by the terms of the mortgage. As I’ve stated above, the statute prohibits a servicer from obtaining force-placed insurance unless a reasonable basis exists to believe the borrower has failed to comply with the loan contract’s requirements to obtain property insurance.

According to RESPA Section 6(l), a servicer of a federally related mortgage loan does not have a reasonable basis for obtaining force-placed insurance unless the following requirements have been satisfied:

• The servicer may not impose any charge on any borrower for force-placed insurance unless the servicer has sent, by first-class mail, a written notice to the borrower containing:

1. a reminder of the borrower’s obligation to maintain hazard insurance on the property securing the loan;
2. a statement that the servicer does not have evidence of insurance coverage;
3. a clear and conspicuous statement of the procedures by which the borrower may demonstrate that insurance coverage is in place; and
4. a statement that the servicer may obtain coverage at the borrower’s expense if the borrower does not demonstrate existing coverage in a timely manner.

• The servicer has sent, by first-class mail, a second written notice, at least 30 days after the first mailing, containing the same information as the first notice.
• The servicer has not received from the borrower any demonstration of hazard insurance coverage by the end of the 15-day period that began on the date the servicer sent the second notice.
• The servicer must accept any reasonable form of written confirmation from a borrower of existing coverage, which must include the existing insurance policy number along with the identity of, and contact information for, the insurance company or agent, or as otherwise required by the Bureau.
• Within 15 days of receipt by the servicer of confirmation of a borrower’s existing insurance coverage, the servicer must: (1) terminate the force-placed insurance; and (2) refund to the consumer all force-placed insurance premiums paid by the borrower during any period during which the borrower’s insurance coverage and the force-placed insurance coverage were in effect, and any related fees charged to the consumer’s account with respect to the force-placed insurance during that period.

Onto the litigation!

The U.S. Court of Appeals for the 3d Circuit considered the allegation regarding the violation of Section 8, where force-placed insurance is a good deal for a lender because the insurer compensates the lender and may even be closely related to the lender.[i]

We are now about to enter the realm of a potentially dispositive doctrine!

The court disposed of the matter using an insurance principle, tossing the issue into the state arena that typically governs insurance practices. States regulate the insurance market to ensure that insurers don’t charge too much (and earn exorbitant profits) or too little (and be rendered insolvent because of unexpected claims) and prevent insurers from unfairly discriminating against certain insureds. Accordingly, states generally require insurers issuing policies in their states to file the rates they will charge with a state department of insurance.

Introducing the filed-rate doctrine! 

The filed-rate doctrine prohibits an insurer from charging rates other than those properly filed with the appropriate regulator. The doctrine also provides that insurance policyholders may not challenge in court a rate filed with a regulator. Instead, they must use prescribed administrative procedures with the appropriate state agency to challenge a rate. Court involvement inevitably would introduce price discrimination because winning plaintiffs would wind up paying less than other ratepayers.

The borrowers in Leo v. Nationstar Mortgage alleged that Nationstar Mortgage, their reverse mortgage lender, colluded with an insurance company and a hazard insurance agent to pocket kickbacks on force-placed insurance policies, in violation of the terms of their mortgages, New Jersey’s implied covenant of good faith and fair dealing, the Truth-in-Lending Act (TILA), the New Jersey Consumer Fraud Act, the New Jersey law preventing tortious interference with a business relationship, and the federal Racketeer Influenced and Corrupt Organizations Act (RICO). They claimed that the insurance company had inflated the rate filed with state regulators so it and the agent could return a portion of the profits to Nationstar to induce Nationstar’s continued business. In effect, the borrowers claimed they paid Nationstar more than Nationstar paid the insurance company and the agent.

The district court dismissed the claims, holding that the filed-rate doctrine blocked the claims. The 3d Circuit affirmed. Because the borrowers sought damages tied to an alleged overcharge baked into a rate filed with regulatory authorities, the filed-rate doctrine barred their claims.

Once an insurance rate is filed with the appropriate regulatory body, the court could not effectively reduce it by awarding damages for an alleged overcharge; in other words, the filed-rate doctrine prevents courts from deciding whether the rate is unreasonable or fraudulently inflated. The doctrine applied whether the borrowers challenged the filed rate as unreasonable or challenged an overcharge fraudulently included in the filed rate.

The court observed that the filed-rate doctrine sought to preserve administrative agencies' exclusive role in approving rates by keeping courts out of the ratemaking process. If the court had ruled for the borrowers, the calculation of damages would require a determination of how much the court thought the borrowers should have been charged for hazard insurance, “a new, lower-than-filed-rate price tethered only to our conception of the appropriate kickback-free rate.”

Indeed, I would suggest that the borrowers faced an even bigger obstacle because of the doctrine’s other goal: preventing insurers from engaging in price discrimination among ratepayers. If the court forced Nationstar to pay damages, it would be giving the borrowers a better price for force-placed insurance than other borrowers using a different lender but still obtaining the insurance from the same insurance company.

My observation: the filed-rate doctrine seems to be dispositive in instances as described above. The 3d Circuit pointed out that other U.S. Courts of Appeal had reached the same result, including the 11th Circuit, which dismissed a nearly identical complaint filed by the same attorneys who represented the borrowers in Leo v. Nationstar Mortgage, that case being Patel v. Specialized Loan Servicing[ii]. Similarly, the 2nd Circuit struck down a RICO claim alleging that borrowers had been “fraudulently overbilled” for force-placed insurance “because the [filed] rates they were charged did not reflect secret ‘rebates’ and ‘kickbacks.’”[iii] The 8th Circuit dismissed a RICO claim because the filed-rate doctrine prevented a RICO suit for damages relating to a fraudulent rate.[iv]

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director 

Lenders Compliance Group

___________________________________________

[i] Leo v. Nationstar Mortgage LLC, 2020 U.S. App. (3d Cir. July 1, 2020)
[ii] Patel v. Specialized Loan Servicing, 904 F.3d 1314 (11th Cir. 2018)
[iii] Rothstein v. Balboa Ins. Co., 794 F.3d 256 (2nd Cir. 2015)
[iv] H.J. Inc. v. Northwestern Bell Telephone Co., 954 F.2d 485 (8th Cir. 1992)

Accurate and Reasonable Disclosures

QUESTION

You may feel that our question is unusual. Still, we think it involves concerns that many people have relating to disclosures, particularly how to determine if a disclosure is accurate or inaccurate.

In my experience, this issue comes up a lot. We use document vendors, but we are relying too much on them for accuracy. We found this out the hard way when a regulator found that one of the TILA disclosures was inaccurate and unreasonable.

The idea of accuracy makes sense, but this notion of reasonableness seems pretty subjective to us.

So, we want to know what is considered reasonable in TILA disclosures?

ANSWER

Your question is not as unusual as you may think. Our compliance professionals are often presented with providing guidance on disclosure compliance. We consider several factors, one of which is the reasonableness of the disclosures.

Regulation Z[i] includes several rules regarding disclosures, including the basis on which disclosures must be given, the use of estimates, and the treatment of irregularities.

Here’s a good rule of thumb for you to follow when reviewing a disclosure: it must reflect the terms of the legal obligation between the parties.

For example, suppose a borrower executes an unsecured note that provides for the total debt to be due five years from the date of the loan. In that case, disclosures must be based on the 5-year term, even if the borrower might informally promise to make monthly or quarterly payments of accrued interest. In other words, disclosures must reflect the credit terms to which the parties are legally bound at the outset of the transaction.

Furthermore, under Regulation Z[ii], if any information necessary for an accurate TILA disclosure is unknown to the creditor, the creditor must make the disclosure based on the best information reasonably available and state that the disclosure is an estimate. This provision provides that disclosures may be estimated if the exact information is unknown at the time the disclosures are made. The provision is based on a section of TILA[iii] that authorizes the CFPB to provide by regulation that any portion of the information TILA requires to be disclosed may be given in the form of estimates when the provider of the information is not in a position to know exact information.

Under Regulation Z, a creditor has no liability for an inaccurate disclosure if the necessary information is not reasonably available by the time of consummation. However, even if a disclosure is validly marked as an estimate before consummation, the creditor may still be required to redisclose when more accurate information becomes available by the time of consummation.[iv]

The estimates must be made in good faith, based on the best information reasonably available, and designated as estimates in the segregated disclosures. Under Regulation Z, as to open-end credit[v] and closed-end credit[vi], creditors are required to make disclosures based on the “best information reasonably available” and to state that the disclosure is an estimate when “any information necessary for an accurate disclosure is unknown.”

A case involving a military veteran illustrates the juncture of “best information reasonably available” and when “any information necessary for an accurate disclosure is unknown.” Let’s check it out.

In Pennsylvania, a federal district court recently examined these requirements in light of a lender’s disclosure of property taxes based on an expected exemption for a borrower.[vii] In some states, such as Pennsylvania, a military veteran may be exempted from paying local property taxes under certain circumstances.

Nelson, a retired, 100-percent disabled military veteran, obtained a home mortgage loan from Acre Mortgage. Under a state program, veterans classified as 100-percent disabled could be exempted from paying local property taxes so long as their income fell below a statutory maximum. Although officials made determinations regarding the income-eligibility criteria with the state veterans’ commission, county veterans' offices handled applications for the exemption.

In her loan application, Nelson disclosed a monthly income of $7,086.83, including $1,510 in social security disability benefits, $2,906.83 in non-educational veterans’ benefits, and $2,670 in military pension benefits. She did not disclose any other income, and, at closing, she signed a statement acknowledging the income information to be true and correct.

In conducting its due diligence before closing, Acre Mortgage consulted the county officials to confirm that property taxes could be excluded. Based on Nelson's income information to Acre Mortgage, county officials informed Acre Mortgage that Nelson should be eligible for the property tax exemption. Nelson also had previously spoken with county officials.

One or two days before closing, Acre Mortgage again contacted county officials to confirm Nelson’s eligibility for the tax exemption, and the county informed Acre Mortgage that, based on the income information submitted to the lender, she was eligible, but that the exemption could not be formally granted until Nelson had title to the property. Accordingly, Acre Mortgage excluded property taxes from the loan disclosures and closing documents.

In December 2015, after closing, Nelson applied for the veteran property tax exemption. In February 2016, the state veterans’ commission notified her that she was not eligible for an exemption because she received educational benefits that increased her income above the statutory maximum for eligibility.

Nelson completed a graduate degree program in May 2016 and then no longer received educational veterans’ benefits. Her income fell below the statutory maximum, and in 2017 she was granted the tax-exempt status.

She sued Acre Mortgage, including TILA violations among other claims. She claimed that Acre Mortgage had provided disclosures on the wrong forms (by failing to use the Loan Estimate and Closing Disclosure and instead using Good Faith Estimate and other forms that had preceded the implementation of the Loan Estimate and Closing Disclosure), failed to disclose local property taxes, and failed to make a reasonable and good faith determination of her ability to repay the loan.

The court dismissed her TILA claims. Evidence showed that Nelson had failed to disclose her educational veterans’ benefits as income and further indicated that Acre Mortgage had relied on the representations of both Nelson and county officials regarding her eligibility for the disabled veterans’ property tax exemption. Evidence also showed that Acre Mortgage had acted in good faith and exercised due diligence in seeking to determine whether property taxes could be excluded from her estimated monthly payment and other mortgage loan disclosures.

In addition, evidence showed that Acre Mortgage had based the TILA disclosures on the best information reasonably available at the time the disclosures were provided and had clearly stated that the disclosures were estimates.

Finally, evidence showed that the ability-to-repay determination was based on the best information reasonably available at the time of loan consummation. No reasonable jury could have returned a verdict in favor of Nelson with respect to whether Acre Mortgage had made a reasonable and good faith determination of ability to repay or whether Acre Mortgage had adequately disclosed Nelson’s local property tax obligations or estimated monthly payments.

The court also held that Acre Mortgage had used the proper disclosure forms, as the TRID disclosure forms (viz., Loan Estimate and Closing Disclosure) were not required until after Nelson submitted her loan application.

TRID disclosure requirements took effect for applications received on or after October 3, 2015, but Acre Mortgage received Nelson’s application on September 24, 2015.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[i] § 1026.17(c)
[ii] § 1026.17(c)(2)
[iii] TILA § 121(c), 15 U.S.C. § 1631(c)
[iv] As set forth in Regulation Z § 1026.17(f), see “early disclosures when a subsequent event renders them inaccurate.”
[v] §§ 1026.5(c)
[vi] 1026.17(c)(2)
[vii] Nelson v. Acre Mortgage & Finance, Inc., 2020 U.S. Dist. (M.D. Pa. Sept. 25, 2020)

Servicer’s Timely Payment of Taxes

QUESTION
We are a mid-size servicer, and I am in charge of our escrow account services. A few days ago, we realized that our policy documents do not fully explain our responsibility to make tax payments.

Specifically, we do not state what constitutes the timely payment of taxes. However, we do show timely tax payments in our procedures.

So, we want to align our policy with our procedures. This review has led us to contact your Servicer Compliance Group to work with us on all our policies and procedures.

In the meantime, regarding the timely payment of taxes, can you provide some perspective and context?

ANSWER
This is an important question. In fact, there has been considerable litigation on the timeliness of tax payments. Every mortgage service must have policies and procedures fully aligned for the timely payment of taxes. I will begin my response by explicating what the term "servicer" means.

I appreciate that you have been in touch with our Servicers Compliance Group to work on the policies and procedures. Keep in mind that many regulations are interlocking, and policies and their implementing procedures should consider the cascading effect of errors multiplying due to improper integration of all applicable regulatory compliance factors.

When the terms of any federally related mortgage loan require the borrower to make payments to an escrow account, RESPA and its implementing Regulation X require[i] the servicer to make disbursements in a timely manner. The phrase “timely manner” is defined as "on or before the deadline to avoid a penalty." This requirement does not apply when the borrower’s payment is more than 30 calendar days overdue.

Regarding property taxes, if the taxing jurisdiction neither offers a discount for disbursements on a lump sum basis nor imposes any additional charge or fee for installment disbursements, the servicer must make disbursements on an installment basis, unless the servicer and borrower otherwise agree.

Furthermore, if the taxing jurisdiction offers a discount for disbursements on a lump sum annual basis or imposes any additional charge or fee for installment disbursements, the servicer may, at its discretion – although it is not a RESPA requirement – make lump sum annual disbursements, as long as that method of disbursement complies with the timeliness requirements of Regulation X.[ii] RESPA encourages,[iii] but does not require, the servicer to follow the preference of the borrower if the servicer knows that preference.

Here’s an example that helps me to expand this discussion. A recent decision by the U.S. Court of Appeals for the 4th Circuit considered the meaning of the term "servicer" insofar it relates to the timely payment of taxes. The case is Harrell v Freedom Mortgage Corp.[iv] In brief, the issue, which arose as a result of a transfer of servicing, was:

(1) whether RESPA requires taxes to be paid by the entity responsible for servicing the mortgage at the time the tax payment is due, or

(2) whether RESPA demands that the entity that received funds for escrow make the tax payment when it is ultimately due.

In 2005, Harrell bought a home and financed its purchase with a loan from NYCB Mortgage Company. In 2012, Harrell refinanced with NYCB because interest rates had dropped significantly. His mortgage contract required him to make property tax payments to NYCB for deposit into an escrow account. This triggered a corresponding obligation under RESPA for NYCB to pay his property tax bills on time.

The mortgage permitted NYCB to sell the mortgage loan and transfer the servicing rights. In 2017, NYCB sold Harrell’s loan, as part of a much larger transaction, to Freedom Mortgage Corp. Freedom took over all servicing rights and responsibilities, effective October 31, 2017. Starting November 1, 2017, Harrell became obligated to pay his mortgage payments to Freedom.

Let’s now look at certain dates.

• NYCB made Harrell’s June 2017 tax payment by its due date, but the November 2017 payment was late.
• Before October 31, 2017, Harrell had deposited the funds in the escrow account overseen by NYCB.
• Ownership of the loan and the servicing rights transferred from NYCB to Freedom on October 31, 2017.
• The November 15, 2017 due date for property taxes came and went, while Harrell’s funds remained in escrow.
• In 2018, Freedom finally made the tax payment from Harrell’s escrow account, but the tax jurisdiction assessed late payment penalties and the tardy payment adversely affected Harrell’s 2017 income tax bill in the amount of $895.

Harrell filed a putative class action against Freedom, alleging that Freedom’s failure to make a timely tax payment violated RESPA, breached his mortgage contract, and was negligent. Freedom responded by disclaiming responsibility, arguing that it, Freedom, was not the "servicer" responsible for the November 15 tax payment and that NYCB was responsible. The district court agreed with Freedom and granted Freedom’s motion to dismiss.

But the 4th Circuit reversed. By requiring "the servicer" to make tax payments "as [they] become due," RESPA connects the servicer’s obligation to a payment’s due date, not the date of payment into escrow by the borrower.

Therefore, the relevant "servicer" under RESPA is the entity "responsible for servicing" the mortgage loan when the tax payment is due.

Harrell sufficiently alleged that Freedom bore the responsibility for servicing his mortgage on the tax’s due date, so under RESPA, Freedom was “the servicer” accountable for making the tax payment on time.

The court noted that its role was not to ask how NYCB and Freedom had agreed by contract to allocate servicing responsibilities between themselves. Instead, its inquiry focused on what the statute requires.

I would like to drill down further to make the foregoing outline more succinct.

First, the statute establishes the obligation for a servicer to make payments from the escrow account for taxes:

"If the terms of any federally related mortgage loan require the borrower to make payments to the servicer of the loan for deposit into an escrow account for the purpose of assuring payment of taxes, insurance premiums, and other charges with respect to the property, the servicer shall make payments from the escrow account for such taxes, insurance premiums, and other charges in a timely manner as such payments become due."

The court noted that two factors triggered the servicer’s obligation to make payments:

(1) Harrell’s loan qualified as a "federally related mortgage loan," which encompasses virtually every residential real estate transaction closing in the United States; and

(2) the terms of Harrell’s loan required Harrell to make tax payments into an escrow account.

Accordingly, Harrell’s servicer had to make tax payments from the escrow account as they became due, or Harrell could seek actual damages, statutory damages, costs, and attorneys’ fees.

Second, RESPA defines the term "servicer" to mean “the person responsible for servicing of a loan." The court combined that definition with the way RESPA[v] uses the word "servicer." That subsection connects "the servicer’s” responsibility to effect payment to the date that payment "becomes due" – in other words, the date by which payment is required. The subsection does not mention when or whether a payment is received into escrow from a borrower. This contemplates that whoever is “the servicer” when a payment becomes due must make that payment.

Third, RESPA also defines the term “servicing” as used in the phrase “the person responsible for servicing of a loan:”

"[R]eceiving any scheduled periodic payments from a borrower pursuant to the terms of any loan, including amounts for escrow accounts…, and making the payments of principal and interest and such other payments with respect to the amounts received from the borrower as may be required pursuant to the terms of the loan."

Harrell’s complaint plausibly alleged that Freedom was responsible for servicing his mortgage loan on November 15, 2017, the tax payment due date, by saying that "NYCB transferred [his] mortgage…, including the servicing of [his] loan, to Freedom" before November 15, 2017. The NYCB-to-Freedom purchase agreement confirmed that, as of November 1, 2017, Freedom acquired "all right, title and interest of [NYCB]…as Servicer under the Servicing Agreements" and "the related Servicing obligations as specified in each Servicing Agreement." Accordingly, Freedom agreed to "assume, pay, perform and discharge the obligation to service the Serviced Loans…on and after" that date.

Because Harrell’s mortgage payments became due to Freedom on November 1, 2017, that was the “effective date of transfer” of his loan under RESPA. RESPA contemplates that before this date, NYCB was the servicer. From this date forward, Freedom became the servicer.

Thus, it is appropriate for the court to conclude that RESPA places the obligation to pay taxes with the entity responsible for servicing a loan when that tax payment is due. In this case, that entity was Freedom Mortgage.

Allow me to offer a few observations.

Freedom argued that because servicing includes "making the payments of principal and interest and such other payments with respect to the amounts received from the borrower," and NYCB had received Harrell’s escrow payment, that made NYCB the servicer. But the court said this confused the statutory duties of “servicers” with the definition of "servicing." Instead, RESPA obligates “the servicer” to make timely payments from an escrow account.

The court noted that an intuitive assumption seemed to underlie Freedom’s argument, to wit, that an intermediary that receives a payment should be responsible for forwarding that payment along to the ultimate recipient. While that assumption might hold in normal transactions, it ignored the use of escrow accounts under RESPA.

Thus, here is the essential policy statement that should align with procedures:

• Borrowers do not make payments simply to a servicer; rather, they make payments to a servicer for deposit into an escrow account.
• The servicer controls the account in trust; the account is not the servicer’s account.
• Transferring servicing involves transferring control over the escrow account. 

Accordingly, there is no interpretive problem with a transferor servicer depositing a borrower’s payment into escrow and the transferee servicer being obligated to disburse those funds.

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director

Lenders Compliance Group

___________________________________
[i] §§ 1024.17(k)1) and 1024.34(a)
[ii] § 1024.17(k)(1) and (k)(2)
[iii] Idem. Paragraph (k)(3)
[iv] Harrell v. Freedom Mortgage Corp., 2020 U.S. App. (4th Cir. Oct. 2, 2020)
[v] RESPA § 6(g), 12 U.S.C. § 2605(g)

The "Superpriority" Lien

QUESTION
I hope you will take my question. I am counsel to several banks that provide loan resources to HOAs. I have always held the position that HOA liens have superpriority, and they do not violate takings or due process.

My concern involves proper notice from an HOA that involves superpriority issues with respect to the Takings Clause and Due Process. I know this can be kind of tricky. I would like your view.

So, in the context of an HOA, how do the Takings and Due Process Clause impact the superpriority lien?

ANSWER
Let’s begin by providing a brief discussion about the meaning of “superpriority.” With respect to Homeowners Associations (HOAs), many states offer “super – priority” of HOA liens set up in connection with townhouse, condominium, and other housing developments. In other words, applicable statutes grant an HOA a lien on its members’ residences for unpaid assessments and charges, rendering that portion superior to all other liens, including the first deed of trust held by the mortgage lender.

Lenders that extend mortgage loans secured by homes located within these HOA developments must be aware of the risk that a borrower might not pay HOA assessments when due, leading to the HOA’s foreclosure in the exercise of its superpriority lien. Accordingly, they need to pay attention to any foreclosure notices they receive regarding HOA proceedings.

Now to expand on your question. I will provide a response by citing recent litigation. The U.S. Court of Appeals for the 9th Circuit considered a bank's desperate attempt to rescue its security interest in a home lost to HOA foreclosure.[*]

Carrasco and Kongnalinh bought a house within the Copper Creek Homeowners Association, financing the purchase with a loan from Wells Fargo Bank secured by the home. The homeowners fell behind on their HOA dues, and the HOA recorded a lien for the delinquent assessments. The HOA foreclosed on the property to satisfy the lien, and Mahogany Meadows Avenue Trust bought the property for $5,332 at a public auction, extinguishing Wells Fargo’s deed of trust.

Wells Fargo conceded that it had received actual notices of the foreclosure sale but argued that the contents of the notices were constitutionally deficient because they did not state that the HOA was foreclosing to satisfy the superpriority portion of the lien, how large the superpriority portion was, or that Wells Fargo’s own lien was in jeopardy. Wells Fargo received precisely the notice prescribed by the statute.

Wells Fargo brought a quiet title action against Mahogany Meadows, the HOA, and the HOA’s agent, seeking a declaration that the foreclosure sale was invalid and Wells Fargo’s deed of trust “continues as a valid encumbrance against the Property,” which had been worth about $200,000. Wells Fargo asserted that the Nebraska state law giving the HOA lien superpriority violated the Takings Clause and the Due Process Clause of the U.S. Constitution.

The Takings Clause and Due Process Clause refers to the Fifth Amendment of the Constitution, where provisions concerning the due process of law and just compensation are explicated.

Check out the commodiously, unexpurgated legalese of the text itself; then I’ll make it easy on the eye with a brief translation:

No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or public danger; nor shall any person be subject for the same offence to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

Brief translation: private property cannot be taken for public use without just compensation.

“Just compensation” typically means, in this context, that the property owner has to receive at a minimum the fair market value of the property in its best alternative use – independent of the government taking.

Now, let’s return to the case. 

The district court dismissed the complaint and the 9th Circuit affirmed.

First, the “superpriority” statute did not facilitate an uncompensated taking of property or violate the Due Process Clause. The Takings Clause, which states “Nor shall private property [including liens such as Wells Fargo’s deed of trust lien] be taken for public use, without compensation,” governs the conduct of the government, not private actors. The HOA, which conducted the foreclosure, was not an arm of the State of Nebraska.

The U.S. Supreme Court has held that “[p]rivate use of state-sanctioned private remedies or procedures does not rise to the level of state action.” Although Nevada law authorized the HOA’s action, that authorization did not make the HOA’s action government action sufficient to invoke the Fifth Amendment.

Second, because the enactment of the state statute had predated the creation of Wells Fargo’s lien, Wells Fargo could not establish that it suffered an uncompensated taking. The statute was enacted in 1991, the HOA covenants and restrictions were recorded in 2003, and both of these things happened before Wells Fargo acquired its lien. Thus, the interest Wells Fargo asserted – that is, the right to maintain its lien unimpaired by a later HOA lien – was not part of its title to begin with. To be sure, when background principles of state law already serve to deprive the property owner of the interest it claims to have been taken, it cannot assert a claim under Takings Clause.

Wells Fargo had options. It easily could have avoided the harsh result by deeming a lien subject to the statutory scheme inadequate security for its loan and refusing to lend. Or, Wells Fargo could have paid off the HOA lien to avert loss of its security, or established an escrow for HOA assessments to avoid having to use its own funds to pay delinquent dues.

Third and finally, regarding due process, because Wells Fargo did not dispute that it received actual notice, its due process rights were not violated.

Wells Fargo did not argue that it was particularly unsophisticated so that a level of notice that might be adequate for an average person would be inadequate for it. Instead, it argued that the notice contemplated by the statute was insufficient. If that were correct, then the notice would be equally insufficient for any holder of an interest in the property, which would mean that essentially all applications of the statute would be invalid. Yet the court had already held the opposite in an earlier decision.

So, here’s my observation.

As I see it, the 9th Circuit rejected Wells Fargo’s assertion that it could not have known about the potential impairment of its lien because even though the statute had been enacted before it acquired its lien, only in a Nevada Supreme Court decision rendered after Wells Fargo obtained its lien “did the [court] radically reinvent [the statute] and hold that it not only granted a homeowner’s association first-payment priority during foreclosure, but that foreclosure of such a lien also destroyed every other lien on the property.”

The Nevada Supreme Court had explained that its decision did not change the law, but “did no more than interpret the will of the enacting legislature.” If the Nevada courts wished to treat that interpretation as reflecting the statute's meaning from the day it was enacted, no principle of federal constitutional law prevented them from doing so.

Furthermore, the 9th Circuit noted that no contrary interpretation had been established before the Nevada Supreme Court decision. The Takings Clause only protects property rights as they are established under state law, not as they might have been established or ought to have been established.

Several points, therefore, deserve reiteration.

The creditor easily could have avoided the harsh result of the decision. It could have refused to lend because of the statutory superpriority scheme. Alternatively, as part of the loan setup, it could have made the loan and implemented a procedure, including training, to assure receipt, and employee understanding of, notices from the HOA. Upon receiving notice, the creditor could have paid off the HOA lien to prevent loss of its security. From the beginning of the loan, the creditor could have required an escrow account for HOA assessments and coordinated payments with the HOA.

Jonathan Foxx, Ph.D., MBA
Chairman & Managing Director 

Lenders Compliance Group

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[*] Wells Fargo Bank v. Mahogany Meadows Ave. Trust, 979 F.3d 1209 (9th Circuit 2020)