Compliance Through a New Lens: Lessons from the Mortgage Crisis

In the ecosystem of real estate finance, it is essential to have an effective means of returning unwanted or unsustainable properties back to the market in an ethical, efficient and compliant manner.  When the secondary market for real estate assets is not operating optimally, the most common means for handling defaulted properties is through foreclosure. Provided that due process requirements have been met and that statutory or court rules have been followed, the foreclosure process is routine.  But many of the underlying legal requirements involved in a “simple” foreclosure have significant legal repercussions if they are over-simplified for efficiency.  Our firm, Manley Deas Kochalski, provides default litigation services to financial institutions, mortgage servicers and resort developers.  The experience of our banking and mortgage servicing clients during the crisis may serve as a cautionary tale about the risks associated with seemingly benign legal and administrative aspects of foreclosures.

In the fall of 2010, an employee at a major mortgage servicing company gave deposition testimony in a litigated foreclosure case.  The employee testified that he had executed several thousand affidavits every month to be used in judicial foreclosure cases. In order to maintain such a high level of production, the affidavit process had been routinized by eliminating or reordering critical steps in the process. An affidavit is based upon the personal knowledge of the affiant after a review of the mortgage servicing records.  The employee testified that satisfying this requirement was not possible at the volume that was expected, and he believed the information contained in the affidavits was accurate due to the fact it was pulled from the servicing system. The employee also testified that the affidavits were not executed in the presence of a notary.  Rather, they were later notarized in a separate setting for efficiency. These affidavits had been filed in thousands of foreclosure cases.

The story hit the news outlets and became a scandal that plagued the mortgage finance industry for several years. The OCC, DOJ and other regulatory bodies began investigations into the document execution practices of the industry, revealing a number of irregularities caused by prioritizing efficiency over compliance. The resulting actions taken by regulators culminated in extremely expensive remediation measures, extraordinary fines and significant reputational damage.

While the practices that caused the document execution scandal were fodder for the press, it is easy to understand how the situation arose.  In 2006, mortgage default rates were less than 1% of most prime portfolios.  By 2010, that number jumped to 7%. Mortgage servicers collect mortgage payments on behalf of investors and when payments are not made, refer defaulted loans to counsel for foreclosure. They also provide supporting documentation, including affidavits, to counsel for legal proceedings. With a seven-fold increase in the number of cases being managed, many servicers created processes with a focus on production and timelines. The urgent need to efficiently move cases forward clouded an analysis of the legal requirements. At the time, it was a common belief in the industry that verifying account information in an affidavit was a “procedural technicality” because almost all affidavits that were later audited for accuracy proved to contain accurate facts. This belief is anathema to any lawyer or judge.

So, why does this story matter to the readers of Developments? While the timeshare industry has not seen the level of consumer litigation present in the mortgage industry, the number of suits is increasing including class actions filed in late 2018. Consumer attorneys are utilizing litigation tactics familiar within the mortgage industry that base suits on highly technical theories under the Fair Debt Collection Practices Act (“FDCPA”).  The FDCPA is a strict liability statute, meaning that technical violations trigger statutory damages regardless of the defendant’s intent. The statute also requires that communications need only confuse the “least sophisticated consumer” to be violations. Both of these factors give plaintiffs’ attorneys a wide berth in filing actions against debt collectors.

Currently there are four cases pending in the Middle District of Florida. The high volume of defaulted timeshare segments has given rise to the practice of handling cases in large batches to reduce cost. In one notable individual action, a borrower brought an FDCPA claim against a debt collector that disclosed the defaulted debts in an omnibus report of delinquent debtors. Such a practice is impermissible under the FDCPA as it prohibits disclosing information about a debt to unrelated third parties.  Another case relates to whether a foreclosure proceeding is the appropriate process for the recovery of a points-based timeshare interest that is not secured by real estate.

It is not clear if these recent actions are a harbinger of consumer litigation to come for the timeshare industry. The United States Supreme Court is considering the question of whether a trustee in a non-judicial foreclosure is considered a debt collector under the FDCPA.  Obduskey v. McCarthy & Holthus LLP, S.Ct. No. 17-1307, cert. 879 F.3d 1216 (10th Cir. 2018). If the answer is no, it could soften the momentum of consumer attorneys in the foreclosure context.  If the answer is yes, it could embolden the consumer bar.   Given the high-volume nature of recovering defaulted timeshare segments, a failure of compliance can be replicated hundreds, if not thousands, of times.  Consequently, consumer attorneys seek class action status for these claims. Maintaining a focus on compliance, with all applicable laws, regulations and court rules, however seemingly mundane, is critical in protecting the reputation of developers and the industry as we enter an increasingly litigious environment.

‍*This article appeared in the April/ May 2019 issue of Developments Magazine.