September 20, 2010

Litigation Implications of the Dodd-Frank Financial Reform Act

Times are changing for consumer finance litigators.

Change is on the horizon for consumer finance litigators. On July 21, 2010, President Barack Obama signed into law the largest financial regulatory overhaul since the Great Depression, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. No. 111-203, H.R. 4173, the Act). The Act's stated purpose is to "promote the financial stability of the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, [and] to protect consumers from abusive financial services practices." While the majority of the Act's provisions require new regulations that will, in time, dramatically change the litigation landscape, there are some provisions that will begin to influence consumer finance litigation immediately.

This article will discuss the major changes to the Truth in Lending Act (TILA) and the Real Estate Settlement and Procedures Act (RESPA), outline the newly created Bureau of Consumer Financial Protection, and conclude with several questions that will remain unanswered well after the Act's effective date.

New Claims, New Defenses, and New Penalty Provisions

New Claims Available to Consumers

Title XIV of the Act significantly amends TILA as it relates to mortgage origination and residential mortgage loans. A "mortgage originator" is defined as any person "who, for direct or indirect compensation or gain," takes a residential mortgage loan application, assists a consumer in obtaining or applying to obtain a residential mortgage loan, or offers or negotiates terms of a residential mortgage loan. (Sec. 1401(2)(A)) It also includes any person "who represents to the public" that he can or will provide the above services. (Sec. 1401(2)(B)). Under the amendments, mortgage originators are now subject to two claims by consumers: (1) violation of the duty of care and (2) violation of the prohibition on steering incentives.

The duty of care for mortgage originators is twofold: (1) originators must be qualified, registered, and licensed under the SAFE Act and state law and (2) loan documents must include the unique qualifier provided by the Nationwide Mortgage Licensing System Registry. (Sec. 1402) This duty is subject to additional regulation by the Bureau of Consumer Financial Protection and consumers have a claim if it is violated. (Sec. 1404)

Additionally, mortgage originators are subject to a prohibition on steering incentives. In the amended TILA, a mortgage originator cannot be paid compensation that varies based on the terms of the loan, other than the amount of the principal. (Sec. 1403) Moreover, no person other than the consumer may pay the mortgage originator an origination fee or charge unless it is a bona fide third-party charge not retained by the creditor, mortgage originator, or an affiliate of the creditor or mortgage originator. The only exception allows a nonconsumer to pay a fee if the consumer does not pay any compensation directly to the mortgage originator and the consumer does not make any upfront payment of discount points, origination points, or fees. Consumers have a cause of action for violation of this prohibition as well. (Sec. 1404) Moreover, the Board of Governors has authority to prescribe regulations to prohibit the steering of any consumer to a residential mortgage loan that the consumer lacks a reasonable ability to repay or that has predatory characteristics or effects (including equity stripping, excessive fees, or abusive terms). (Sec. 1403) The Board also may prescribe regulations prohibiting a mortgage originator from steering a consumer from a qualified mortgage to a nonqualified mortgage. These yet-to-be-promulgated regulations also create a right of action for the consumer and are subject to the same damages provision. (Sec. 1404 (creating a cause of action when a mortgage originator fails "to comply with any requirement imposed under this section and any regulation prescribed under this section"))

The damages available to consumers for a mortgage originator's violation of the duty of care or violation of the prohibition on steering incentives include "the greater of actual damages or an amount equal to 3 times the total amount of direct and indirect compensation or gain accruing to the mortgage originator in connection with the residential mortgage loan involved in the violation, plus the costs to the consumer of the action, including a reasonable attorneys' fee." (Sec. 1404)

TILA also provides that no creditor may make a residential mortgage loan until it makes a "reasonable and good faith" determination that the consumer has a "reasonable ability to repay" the loan. (Sec. 1411) A creditor makes this determination by considering a variety of factors enumerated in the Act. This requirement is similar to the "ability to repay" factor in many states' consumer protection laws governing unconscionable loan transactions. Thus, many litigators are already dealing with this issue on the state level. By including the "reasonable ability to repay" in TILA, the federal government is similarly prohibiting "unconscionable" conduct at the federal level.

Violation of the reasonable ability to repay subjects the creditor to consumer claims. The damages available to consumers include all damages under 15 U.S.C. § 1640(a), including

  1. any actual damage sustained by the person as a result of the failure;
  2. twice the amount of any finance charge in connection with the transaction or in an action relating to a credit transaction not under an open-end credit plan that is secured by real property or a dwelling, a penalty not less than $400 or greater than $4,000; and
  3. an amount equal to the sum of all finance charges and fees paid by the consumer unless the creditor demonstrates that the failure to comply is not material.

15 U.S.C. § 1640(a); Sec. 1416.

The Act provides creditors with one safe harbor—a rebuttable presumption that a consumer has a reasonable ability to repay all "qualified mortgages." (Sec. 1412) Under the Act, "qualified mortgage" is defined according to the following criteria:

  • the periodic payments must not result in an increased principal balance, nor allow the consumer to defer repayment;
  • the terms must not result in a balloon payment (unless allowed by federal regulation);
  • income resources must be on file and verified;
  • for fixed-rate loans the payment schedule must fully amortize and include all taxes, insurance, and assessments;
  • for adjustable rate loans, the payment schedule must be based on the maximum rate permitted during the first five years;
  • it must comply with the Bureau's regulations relating to ratios of total monthly debt to monthly income;
  • total points and fees cannot exceed 3 percent of the total loan amount; and
  • the term of the loan cannot extend beyond 30 years (except in high-cost areas).

However, the Board of Governors has the authority to "prescribe regulations that revise, add to, or subtract from the criteria that define a qualified mortgage" and to include balloon loans within the definition. (Sec. 1412)

New Defenses for Consumers in Foreclosure

Consumers also have two new defenses to foreclosure: (1) if the newly created prohibition on steering incentives is violated by a mortgage originator or (2) if a creditor violates the reasonable ability to repay requirement. This section will discuss the two new consumer defenses.

Essentially, consumers have a defense of setoff or recoupment against a creditor, assignee, or holder in a foreclosure action or collection action if the creditor violates the newly created "reasonable ability to repay" provision or the mortgage originator violates the prohibition on steering incentives. The amount of setoff or recoupment is "equal to the amount to which the consumer would be entitled under subsection (a) for damages for a valid claim brought in an original action against the creditor, plus the costs to the consumer of the action, including a reasonable attorney's fee." (Sec. 1413) As noted above, TILA's civil liability provision provides that a consumer, in an original action, is entitled to actual damages, twice the amount of any finance charge or a penalty not less than $400 or greater than $4,000, and an amount equal to the sum of all finance charges and fees paid by the consumer. See 15 U.S.C. § 1640(a).

Therefore, the amount set off will include all of the damages above, plus reasonable attorneys' fees and costs. Because consumers are provided an independent action for violation of these provisions, they also can counterclaim, if within the statute of limitations period, and recover any amount of damages above the setoff.

If the newly created three-year statute of limitations runs, the consumer is entitled to the amount of setoff or recoupment up to the date of the running of the limitations period. (Sec. 1413)

New Defenses for Creditors

Under the Act, creditors have two new, but narrowly drawn defenses to TILA violations. The first defense is one for fraud on the part of the consumer. Specifically, the civil liability provision in TILA provides a new subsection stating "no creditor or assignee shall be liable to an obligor under this section, if such obligor, or co-obligor has been convicted of obtaining by actual fraud such residential mortgage loan." (Sec. 1417 (emphasis added)) This defense protects creditors or assignees from rescission or damages only if the consumer is convicted of fraud in obtaining the mortgage loan. This defense provides no protection for creditors or assignees unless the consumer is convicted of actual fraud. Thus, if a borrower misrepresents information on his application, the misrepresentation alone is insufficient to provide the creditor with this defense.

The second new defense available to creditors or assignees is a "cure" defense. In the case of a creditor or assignee failing to satisfy any requirement under 15 U.S.C. § 1639, a creditor or assignee is protected from liability if it establishes either:

  1. within 30 days of the loan closing and prior to the institution of any action, the consumer is notified of or discovers the violation, appropriate restitution is made, and at the choice of the consumer, the loan is changed to satisfy the requirements or the terms are changed so the loan is no longer high-cost.
  2. within 60 days of the creditor's discovery or receipt of notification of an unintentional violation or bona fide error and prior to the institution of any action, the consumer is notified of the compliance failure, appropriate restitution is made, and at the choice of the consumer, the loan is changed to satisfy the requirements or the terms are changed so the loan is no longer high-cost.

Thus, any violation, either intentional or unintentional, will not subject a creditor or assignee to liability under TILA if, within 30 days of the loan closing and prior to the institution of an action by the consumer, the violation is corrected. If the violation is unintentional or the result of a bona fide error, the creditor or assignee has 60 days to make corrections before becoming subject to liability.

Just as the fraud defense provides only limited protection for creditors or assignees, the corrective measures defense provides protection only when the creditor or assignee corrects the violation prior to the consumer instituting suit.

New Penalty Provisions and Extension of Statute of Limitations

In addition to the significant amendments adding new claims for consumers and new defenses for creditors, the TILA amendments directly affect the civil penalty provisions. First, civil liability is increased to an amount not less than $200, nor greater than $2,000 for violations related to consumer leases. (Sec. 1416) Second, total recovery in class actions is now capped at the lesser of $1 million or 1 per centum of the net worth of the creditor. In addition to greater damages, consumers also are given additional time to bring TILA actions with a three year statute of limitations.

Other Noteworthy TILA Amendments

Under the TILA amendments, a servicer must credit a payment to a consumer's loan account as of the date of receipt. (Sec. 1464) A servicer is excused from immediately crediting the payment when the delay in processing will not affect the consumer's credit report nor result in a charge on the creditor's account. Additionally, servicers and creditors must respond quickly to requests for payoff statements. When a consumer or an individual on behalf of the consumer requests a payoff statement, in writing, the servicer must send the statement within a reasonable time not to exceed seven business days from the date of receipt. Thus, under the newly amended TILA provisions, servicers must streamline processing of information to ensure compliance and avoid increased damages.

Also, TILA is amended to prohibit certain provisions in a mortgage loan or extension of credit, including mandatory arbitration provisions when the loan or extension of credit is secured by a principal dwelling and waivers of statutory causes of action. (Sec. 1414).

RESPA: Stiffer Penalties, Stricter Timelines, and Other Prohibitions

Servicers Are Subject to Stiffer Penalties and Stricter Timelines

In addition to the significant changes to TILA, the Act also makes several changes to RESPA. The amendments to RESPA provide for higher damages and stricter timelines for responding to qualified written requests (QWR). Specifically, borrowers in a class action are now entitled to actual damages and additional damages not to exceed $2,000, per member of the class, when there is a pattern of noncompliance. (Sec. 1463) However, total recovery is capped at the lesser of $1 million (up from $500,000) or 1 percent of the net worth of the servicer. Individuals also are entitled to additional damages not to exceed $2,000 (up from $1,000), if the borrower shows a pattern or practice of noncompliance.

Similar to the limited amount of time provided to servicers and creditors under the new TILA provisions, RESPA time limits for responding to a QWR are decreased significantly:

  1. Time for servicer to provide a written response acknowledging receipt decreased from 20 days to 5 days.
  2. Time for servicer to make appropriate corrections or conduct an investigation reduced from 60 days to 30 days.

(Sec. 1463) These reduced response times are land mines to expose servicers to increased litigation.

A new subsection allows a servicer to request a 15-day extension when the servicer notifies the borrower of the extension and the reason for the delayed response. Without additional resources, servicers may not be able to respond to each QWR within 5 days and perform a thorough investigation in 30 days.

New Rules for Force-Placed Insurance

Force-placed insurance will continue to be a hotly contested issue under the Act. RESPA is amended to prohibit servicers from force-placing insurance without a "reasonable basis"—an undefined term—to believe a borrower has failed to comply with property insurance requirements. (Sec. 1463) A servicer may not impose a charge for force-placed insurance unless the servicer has sent a written notice to the borrower, by first-class mail, stating there is no evidence of coverage and outlining the procedure for a borrower to demonstrate coverage. If the consumer fails to respond to the notice, a second notice is sent 30 days later. If the consumer does not respond to the second notice within 15 days, the servicer may then force-place insurance. The process does not end there.

The servicer must accept "any reasonable form of written confirmation from the borrower of existing insurance coverage"—again "reasonable" is not defined—and cancel force-placed insurance within 15 days of receipt. The premiums for any force-placed insurance must then be refunded to the borrower.

Other Prohibitions on Servicers

RESPA, 12 U.S.C. § 2605(k), now states that a servicer of a federally related mortgage loan is expressly prohibited from

  1. charging fees for responding to valid QWRs (as defined in regulations that the Bureau shall prescribe);
  2. failing to take timely action to respond to a borrower's requests to correct errors relating to allocation of payments, final balances, or other standard servicer's duties;
  3. failing to respond within 10 business days to a request from a borrower to provide the identity, address, and other relevant contact information about the owner or assignee of the loan; and
  4. failing to comply with any other obligation found by the Bureau, by regulation, to be appropriate to carry out the Act.

Any servicer who violates these new prohibitions is liable to the borrower "for each such failure" in the amount of actual damages to the borrower, any additional damages in an amount not to exceed $2,000, and fees and costs incurred in a successful action. 12 U.S.C. § 2605(f)(1) and (3). Accordingly, servicers should be careful not to participate in any of the newly prohibited actions described above.

Preemption: It's a Whole New World

Congress also took away a significant defense for some financial institutions when it changed the standards for preemption in the National Bank Act. Specifically, the Act preempts state consumer financial laws in only three limited situations:

  1. to the extent the law has a "discriminatory effect" on national banks or federal thrifts in comparison with the effect on state banks;
  2. in accordance with the standard for preemption in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner, et al., 517 U.S. 25 (1996), the state consumer financial law "prevents or significantly interferes with the exercise by the national bank of its powers;" or
  3. express preemption by a provision of federal law other than the National Bank Act.

Any preemption determination under Barnett may be made by a court, by regulation, or by the comptroller of currency on a case-by-case basis. Again, this leaves significant issues regarding preemption up to regulations and subsequent litigation, meaning application of the doctrine of preemption may be hotly contested for years.

The Act eliminates state law preemption for all subsidiaries and affiliates of national banks. (Sec. 1044) Under the Act, subsidiaries and affiliates are now exposed to all state laws, including licensing and regulation, and are not provided any protection under Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007). Prior to the Act, subsidiaries and affiliates could claim preemption as a defense under the Watters opinion, which held that a state may not exercise general supervision or control over a subsidiary of a national bank. This decision is now effectively abolished. Without this valuable defense, national banks must decide whether to have their affiliates and subsidiaries immediately comply with state laws that vary across state lines or fold all affiliates into the parent corporation.

This change in existing law is accomplished by an amendment to the National Bank Act providing that neither the National Bank Act nor the Federal Reserve Act "preempt, annul, or affect the applicability of any State law to any subsidiary or affiliate of a national bank." (Sec. 1044 (emphasis added)) And, in even more concrete terms, the Act provides that "a State consumer financial law shall apply to a subsidiary or affiliate of a national bank . . . to the same extent that the State consumer financial law applies to any person, corporation, or other entity subject to such State law." (Sec. 1044 (emphasis added)) While the applicability of preemption for national banks is specifically limited to state consumer financial laws, subsidiaries and affiliates of national banks are now subject to all state laws.

Creation of the Bureau of Consumer Financial Protection

In addition to the amendments to TILA and RESPA and changes in the applicability of the doctrine of preemption, the Act undertakes a significant regulatory overhaul that may have some peripheral effects on litigation. In addition to traditional rulemaking and administrative powers, the newly created Bureau has extensive authority to ensure consumers are protected under the alphabet soup of existing federal consumer protection laws—EFTA, ECOA, FCRA, FDCPA, HMDA, RESPA, SAFE Act, TILA—while potentially creating new requirements through regulation. (See Sec. 1061)

The Bureau is an independent entity established in the Federal Reserve System with its main purpose being to "seek to implement and . . . enforce Federal consumer financial law consistently for the purpose of ensuring that all consumers have access to markets for consumer financial products and services and that markets for consumer financial products and services are fair, transparent, and competitive." (Secs. 1011(a), 1021) In addition to overseeing new regulations related to established federal consumer financial laws, the Bureau has authority to declare an act or practice unfair or abusive for purposes of federal law. (Sec. 1031(c) and (d)) These practices are deemed "unlawful" under the Act and subject to the Bureau's enforcement powers. (Sec. 1036)

If the Bureau determines that a covered person or service provider has engaged in unlawful activity, it may issue a cease and desist order or pursue a civil action, in a federal district court or a state court, for violations of the enumerated federal consumer financial laws. (Secs. 1053, 1054(f)) In either instance, remedies available to the Bureau are broad: rescission or reformation, refund of moneys or return of property, restitution, disgorgement, damages, public notification of violation, and civil monetary penalties.

For civil penalties, the Act creates a "Consumer Financial Civil Penalty Fund" to be maintained and established at a federal reserve bank. If the Bureau receives any "civil penalty against any person in any judicial or administrative action under Federal consumer financial laws," it must deposit it into the fund. (Sec. 1017(d)(1)) The fund is then used to pay "victims of activities for which civil penalties have been imposed under the Federal consumer financial laws." (Sec. 1017(d)(2)) If victims cannot be located or payments are impracticable, the Bureau may use the funds for "consumer education and financial literacy programs."

In sum, the Bureau has sweeping rulemaking, investigative, and enforcement authority to regulate all consumer financial products and services. Through its rulemaking, the Bureau has the ability to promulgate rules that could subject creditors, servicers, or mortgage originators to additional consumer actions. Moreover, the Bureau itself also may bring creditors, servicers, and mortgage originators into court for violations. Thus, while the litigation effects of the Bureau are not immediately apparent, they are far reaching.

Where Do We Go from Here?

Even though the Act spans over 800 pages, several questions remain unanswered, the most obvious question being whether Title X—the Consumer Financial Protection Act of 2010—provides for an implied right of action or a duty of care sufficient for a state law negligence per se action. As noted above, the Bureau and the state attorneys general have civil enforcement authority over violations of the Act. However, there is no mention as to whether consumers themselves may pursue a violation of Title X. When the bill was passed by the House on December 11, 2009, it included a provision providing that the title could not be construed so as to create a private right of action. (Sec. 4508) In contrast, when the bill was referred to the Senate and subsequently enrolled, it did not contain this provision, thereby leaving open the question of whether a private right of action exists for consumers.

The Bureau itself is given new powers, new staffing (including lawyers, economists, etc.), and broad authority to regulate all consumer financial products and services. Therefore, enforcement will depend largely on the funding available to the Bureau. Presumably the Bureau will be well-funded considering its funding comes from the budget of the Federal Reserve System, and is based on an amount requested by the director that cannot exceed 10 percent of the fixed operating expenses for fiscal year 2011, 11 percent for fiscal year 2012, and 12 percent for fiscal year 2013, and each year thereafter. (Sec. 1017)

In addition to providing the Bureau with sweeping power, the Act leaves states with broad authority to regulate and enforce violations of consumer protection laws. For example, the state attorneys general have power to bring civil enforcement actions for violations of the Act and any regulations promulgated thereunder. (Sec. 1042) This authority subjects the enforcement and overall effectiveness of the Act to state funding. The question remains whether states are sufficiently funded to undertake enforcement.

Conclusion

The Act itself mostly represents only a framework for change, making it difficult now to determine how dramatically consumer finance litigation will be affected by its provisions. Over the course of the next year, the Bureau will begin to promulgate regulations, begin investigations, and undertake civil administrative proceedings that will begin to clarify claims and defenses. While this article presents the most readily apparent implications, the authors and other consumer finance litigators will need to continue to evaluate the implications of the Act.

Additional Resources

Resonable Ability to Repay

Basis for Determination—A determination of a consumer's ability to repay a residential mortgage loan shall include

  1. consideration of the consumer's credit history, current income, expected income the consumer is reasonably assured of receiving,
  2. current obligations,
  3. ebt-to-income ratio or the residual income the consumer will have after paying non-mortgage debt and mortgage-related obligations,
  4. employment status, and
  5. other financial resources other than the consumer's equity in the dwelling or real property that secures repayment of the loan.

A creditor shall determine the ability of the consumer to repay using a payment schedule that fully amortizes the loan.

Income Verification—A creditor making a residential mortgage loan shall verify amounts of income or assets that such creditor relies on to determine repayment ability, including expected income or assets, by reviewing the consumer's Internal Revenue Service Form W-2, tax returns, payroll receipts, financial institution records, or other third-party documents that provide reasonably reliable evidence of the consumer's income or assets.

Preemption: State Consumer Financial Laws

The preemption provisions of the Act apply solely to "state consumer financial laws," meaning that the existing preemption standards apply to all laws that are not "state consumer financial laws."

State Consumer Financial Law: A state law that does not directly or indirectly discriminate against national banks and that directly and specifically regulates the manner, content, or terms and conditions of any financial transaction (as may be authorized for national banks to engage in), or any account related thereto, with respect to a consumer.

Because this definition is broad and somewhat vague, only time will tell how the courts and the comptroller of currency define its scope.

Definitions and Background (Secs. 1002, 1018, 1061)

"Covered person" means

  1. any person that engages in offering or providing a consumer financial product or service; and
  2. any affiliate of a person described in subparagraph (A) if such affiliate acts as a service provider to such person.

"Consumer financial product or service'' means any financial product or service that is offered or provided for use by consumers primarily for personal, family, or household purposes; or is delivered, offered, or provided in connection with a consumer financial product or service.

"Service provider" means any person that provides a material service to a covered person in connection with the offering or provision by such covered person of a consumer financial product or service, including a person that

  1. participates in designing, operating, or maintaining the consumer financial product or service; or
  2. processes transactions relating to the consumer financial product or service (other than unknowingly or incidentally transmitting or processing financial data in a manner that such data is undifferentiated from other types of data of the same form as the person transmits or processes).

"Designated Transfer Date"--While the creation of the Bureau occurs on the date of enactment of the Act, the transfer of consumer financial protection functions does not occur until the "designated transfer date." (Sec. 1018, 1061) The "designated transfer date" is prescribed by the Secretary of the Treasury and must be 180 days to 12 months after the Act's enactment, unless the Secretary extends the date to no later than 18 months after enactment. (Sec. 1062)