Mortgage Banking & Consumer Financial Products Alert July 27, 2010 Authors: Philip M. Cedar phil.cedar@klgates.com +1.212.536.4820 Jonathan D. Jaffe jonathan.jaffe@klgates.com +1.415.249.1023 Laurence E. Platt larry.platt@klgates.com +1.202.778.9034 K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. Assignee Liability Is Extended by Massachusetts: Will Others Follow Suit? From the people that brought us assignee and servicer responsibility for presumptively unfair residential mortgage loans, the Massachusetts Attorney General (the Attorney General ) has relied on the common law of aiding and abetting to settle a dispute with Morgan Stanley & Company, Incorporated ( Morgan Stanley ) arising out of the origination of presumptively unfair subprime mortgage loans by New Century Financial Corporation ( New Century ). 1 The settlement with the Attorney General, which it announced on June 24, 2010, calls for the payment of $102 million to Massachusetts borrowers, the State Treasury and two of the state s investment funds. It also requires Morgan Stanley to adopt certain practices in its financing, purchasing and securitizing of subprime loans in the future. The allegations and remedial relief in the settlement are likely to give heartburn to warehouse lenders, loan purchasers, conduit sponsors and securitizers. Nevertheless, the settlement is reflective of the current regulatory climate and consistent with the sections of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2 which extend liability to non-primary actors who knowingly or recklessly participate in a violation of many consumer finance and securities laws. Background As part of an ongoing, market-wide investigation of the financing, purchase and securitization of allegedly unfair residential mortgage loans in Massachusetts, the settlement with the Attorney General focused on loans originated by New Century during 2005 2007. 3 New Century was one of the largest originators of subprime loans in the United States until it filed for bankruptcy in the spring of 2007. A large number of these loans were adjustable rate mortgages ( ARMs ) with initial teaser rates that could potentially reset to a much higher rate. When New Century made ARM loans, it typically qualified borrowers based on payments made at the teaser rate rather than the higher fully indexed rate. The AOD alleges that Morgan Stanley was New Century s largest provider of warehouse lending for the origination of new loans, regularly purchased New Century loans and acted as underwriter for many of New Century s securitizations. The AOD also alleges that as part of Morgan Stanley s loan purchase and securitization processes, it performed due diligence reviews to determine the quality of New Century s lending practices and individual loans, including whether the loans were originated in conformity with New Century s underwriting guidelines and complied with applicable law. In addition, the AOD alleges that during these review processes, Morgan Stanley learned that New Century violated its own internal requirements and Massachusetts law, 4 made loans that borrowers could not afford after the first rate reset date and used inflated appraisals, resulting in loans with real loan-to-value ratios ( LTVs ) in excess of 100 percent.
According to the Attorney General, after Morgan Stanley became aware through its due diligence vendor reports of the underwriting guideline violations and other loan quality issues, it nonetheless continued to provide warehouse funding to New Century to make subprime loans and to purchase a large number of loans found by the vendor to violate the guidelines. The Attorney General s Apparent Legal Theory As discussed in greater detail below, the Attorney General s case against Morgan Stanley appears to be based on the theory that the firm aided and abetted New Century s violation of a requirement under Massachusetts law that a mortgage lender must determine whether a borrower has the ability to repay a prospective loan in accordance with its terms and not in reliance on the assumed ability of the borrower to obtain refinancing. 5 The Attorney General apparently found support for its conclusion in Commonwealth v. Fremont Investment & Loan, a recent decision 6 enjoining one subprime lender from foreclosing on loans determined by the court to be presumptively unfair under the Massachusetts consumer protection statute, 7 even though at the time the loans were made they did not violate any statute or regulation. Among the characteristics that rendered the loans presumptively unfair in Fremont were: (i) introductory periods on ARMs of 3 years or less; (ii) teaser rates 3 percent lower than the fully indexed rate; (iii) borrower debt to income ratios ( DTIs ) that would exceed 50 percent if calculated using the fully indexed rate and (iv) LTV of 100 percent or more. Consistent with the AOD s allegation and the Fremont court s decision, the Attorney General issued regulations making it an unfair and deceptive practice to make a mortgage loan unless the lender reasonably believes that the borrower will be able to repay the loan based upon a consideration of the borrower s income, assets, obligations, employment status, credit history, and financial resources, not limited to the borrower s equity... 8 However, these regulations became effective on January 2, 2008 9 substantially after the conduct described in the AOD. 10 In one short paragraph, the AOD appears to set forth the Attorney General s view of the legal underpinnings of its enforcement efforts against Morgan Stanley on an aiding and abetting theory: From fourth quarter 2005 through first quarter 2007, Morgan Stanley aided and financed the business of originating unfair mortgage loans to Massachusetts borrowers in violation of Massachusetts law in that: Morgan Stanley knew that many borrowers could not repay the loans according to the terms of the loans without refinancing; and Morgan Stanley provided substantial assistance to New Century through its warehouse funding, forward purchasing and other activities that enabled New Century to make these unfair loans to certain Massachusetts borrowers. 11 These borrowers were harmed by Morgan Stanley s actions, according to the AOD. While the precise standards of aiding and abetting liability vary among courts and by context, the AOD s allegations are generally consistent with the essential components of (i) knowledge of a violation of the law; and (ii) substantial assistance to the primary actor. 12 There is at least one judicial predicate for the Attorney General s decision to apply an aiding and abetting legal theory to a major investment bank that provided warehouse financing and securitization services. In In re First Alliance Mortgage Co., the court upheld a jury verdict that Lehman Brothers and an affiliate were liable for aiding and abetting fraud by a subprime lender. 13 Much like the allegations in the AOD, the Ninth Circuit in First Alliance found sufficient evidence to support the verdict that (i) Lehman Brothers had sufficient knowledge from its due diligence inquiries and internal reports of the lender s fraudulent loan July 27, 2010 2
origination processes; and (ii) the firm rendered substantial assistance to First Alliance s business, if not the fraud, when it became the sole source for the lender s warehouse financing and securitization needs. 14 In that case, however, the portion of the losses attributable to the aiding and abetting claim was found to be only 10 percent of the damage award, which equated to a little over $5 million. The Attorney General s efforts to reach Wall Street are consistent with current legislative attempts to expand responsibility to secondary actors in the financial services industry. For example, Dodd-Frank authorizes the Bureau of Consumer Financial Protection to take action against any person who knowingly or recklessly provides substantial assistance in violation of the unfair and deceptive practices provisions of the bill. 15 Similarly, by broadly defining covered person in non-banking contexts, Dodd-Frank extends the reach of the applicable requirements and prohibitions of Title X of the Act to any independent contractor who knowingly or recklessly participates in any (I) violation of any provision of law or regulation; and (II) breach of a fiduciary duty. 16 In addition, the Act authorizes the Securities and Exchange Commission ( SEC ) to impose aiding and abetting liability on persons who recklessly provide substantial assistance to one who violates federal securities law. 17 For more information on the powers of the Bureau and the new consumer financial regulatory regime, see the K&L Gates Financial Services Reform Alert entitled Consumer Financial Securities Industry, Meet Your New Regulator, by Melanie H. Brody and Stephanie C. Robinson. 18 The Relief Imposed Although Morgan Stanley was not the originator or the primary actor with respect to the presumptively unfair loans, peace with the Attorney General did not come cheaply. The AOD requires a $58 million payment for principal reduction and possible foreclosure relief to over 1000 Massachusetts subprime borrowers. In addition to payments of $19.5 million to the state directly, the Attorney General was able to obtain payments of $23.4 million to a state pension plan and a municipal investment vehicle. The only predicate for those payments was a paragraph in the AOD alleging that these two funds purchased certain securities through an intermediary from Morgan Stanley backed by New Century loans, some of which were unfair to borrowers and the state entities suffered significant losses in their investments. 19 To the extent that Morgan Stanley participates in the future in financing, purchase, or securitization of subprime loans defined in the AOD to be loans for which the average FICO score in a pool is 660 or less it agreed to adopt a number of practices designed to prevent violations of Massachusetts law and enhance disclosure to investors. The AOD requires, among other things: (i) future purchases be limited to loans that are not presumptively unfair under then-current Massachusetts law and underwritten using the fully indexed rate; (ii) the use of a process to prevent the purchased loans from violating the BBI; and (iii) with respect to warehouse financing, improved screening for and steps to prevent or remove the extension of credit to originators for loans that violate the BBI statute or are presumptively unfair. However, because loans typically do not remain on a warehouse line long enough for a warehouse lender to perform a meaningful review of a statistically significant sampling of loans, it is unclear whether an early screening program could effectively prevent violative loans from being financed. The Attorney General also secured disclosure relief for Massachusetts investors. In that regard, Morgan Stanley will be required, to the extent not already being provided and not inconsistent with applicable SEC regulations, to disclose to investors material exceptions to underwriting guidelines, as well as loan level and aggregate data showing (i) third party broker price opinions and the effect of using such information on LTVs; and (ii) for ARMs, data reporting on fully indexed rates, borrower monthly income and the effect of using such information on DTIs. July 27, 2010 3
Conclusion In procuring financial relief for distressed borrowers, the Massachusetts Attorney General may have injected material uncertainty into the secondary market as to its responsibility to ensure that mortgage lenders comply with applicable law. Whether Massachusetts would have made similar claims against those who solely provide warehouse lending, or purchase loans, or securitize loans made by others, is not clear. It remains to be seen whether the settlement will embolden this Attorney General, or other governmental enforcement officials at the state and federal levels, to assert aiding and abetting claims against solvent secondary actors based on their participation in the crisis. As firms contemplate a return to warehouse lending and securitization programs, they should consider the Attorney General s allegations and evaluate whether the remedial steps imposed by the Attorney General sensibly apply to their businesses. Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Moscow Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d Alene Taipei Tokyo Warsaw Washington, D.C. K&L Gates includes lawyers practicing out of 36 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates comprises multiple affiliated entities: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), in Tokyo, and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong; a Polish limited partnership (K&L Gates Jamka sp.k.) maintaining an office in Warsaw; and a Delaware limited liability company (K&L Gates Holdings, LLC) maintaining an office in Moscow. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners or members in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. 2010 K&L Gates LLP. All Rights Reserved. 1 2 3 4 5 6 7 8 9 10 11 12 In re Morgan Stanley & Co., No. 10-2538 (Mass. Super. Ct., Suffolk Cty. June 24, 2010), available at http://www.mass.gov/?pageid=cagopressrelease&l=1&l0=home&sid=cago&b=pressrelease&f=2010_06_24_ms_settle ment&csid=cago. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 (2010) ( Dodd-Frank or the Act ). The Attorney General s allegations regarding Morgan Stanley s conduct and the relief agreed to are embodied in an Assurance of Discontinuance ( AOD ) filed in Suffolk Superior Court. Morgan Stanley entered into the AOD for settlement purposes and did not admit or deny the Attorney General s allegations. The AOD alleges that Morgan Stanley provided warehouse financing secured by loans that were alleged to have violated the Massachusetts borrower s best interest rule ( BBI ), which prohibits the refinancing of a home loan made within the prior 60 months unless the lender can demonstrate that the refinancing is in the borrower s interest. MASS. GEN. LAWS ch. 183, 28C (2009); 209 MASS. CODE REGS. 53.03 (2005). AOD 16. Commonwealth v. Fremont Investment & Loan, 452 Mass. 733, 897 N.E.2d 548 (2008). MASS. GEN. LAWS ch. 93A, 2. 940 MASS. CODE REGS. 8.06(15) (2008). A similar statutory requirement predated this regulation, but that statute addressed only high cost home loans. In several enforcement actions, the Attorney General has extended responsibility for presumptively unfair loans to assignees and non-originating servicers by requiring these parties to agree to strict pre-foreclosure clearance procedures. E.g., Commonwealth v. Fremont Investment & Loan, 2008 WL 1913940 (Mass. Super. Ct., Suffolk Cty. March 31, 2008), aff d, 452 Mass. 733, 897 N.E.2d 548 (2008); Commonwealth v. H&R Block, Inc., No. 08-2474-BLS 1 (Mass. Super. Ct., Suffolk Cty. Nov. 10, 2008), aff d, Commonwealth v. Option One Mortg. Co., 916 N.E.2d 422 (Mass. App. Ct. 2008). AOD 43. 10 Fletcher Cyc. Corp. 4882.50 (2010 ed.); RESTATEMENT (SECOND) OF TORTS 876(b) (1979). July 27, 2010 4
13 14 15 16 17 18 19 471 F.3d 977 (9th Cir. 2006). 471 F.3d 977, 992-95. Sections 1036(a)(3), 1031. Section 1002.25. Sections 929M-O. K&L Gates LLP, Washington, D.C., July 7, 2010, http://www.klgates.com/newsstand/detail.aspx?publication=6527. AOD 44. July 27, 2010 5