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Mortgage Servicer Privity with Borrowers

posted by Adam Levitin

A lot of the mortgage servicing litigation over the past seven years has faltered on standing issues. Does the borrower have standing to sue the servicer? This has been a problem for RESPA and HAMP suits, where there are questions about whether there is a private right of action, as well as for plain old breach of contract actions. The point I make in this post is that borrowers almost always have standing to sue the servicer for a breach of contract action arising out of the mortgage loan contract itself because the servicer is an assignee of part of the mortgage note. This was an issue that lurked in the background of a case I recently testified in, and I think it's worth highlighting for the Slips readers.  

A lot of courts have misunderstood the nature of the servicing relationship vis-a-vis the borrower and assumed that because the servicer is not expressly a party to the note and security agreement that there is no privity between the borrower and servicer and hence the borrower cannot maintain a breach of contract suit.  That's wrong. The servicer is not on the note or the security agreement, but the servicer is an assignee of the note, just like the securitization trust, and that provides all the privity needed for a breach of contract suit.  

Legal scholarship has long understood that property can be conceptualized as a bundle of separate rights.  Thus, if I sell you Blackacre in fee simple, absolute, I am conveying to you the right to use Blackacre currently, the right to use it in the future, the right to the products and profits from the land, the right to reconvey it, etc. These rights could be split up:  I could sell you the right to use Blackacre for a year, with the property reverting to me thereafter.  That's just a lease.  Likewise, the mineral rights and the air rights to Blackacre could be sold separately from the surface rights. The same can be done with a mortgage note.

The mortgage note creates several rights for the lender:  a right to payment of principal, a right to payment of interest, a right to late fees, a right to reasonable attorneys fees, a right to sue, etc. That bundle of rights can be sold together, as in a fee simple, absolute transfer of real estate.  But it can also be split up, just like the various rights to Blackacre.  And that's exactly what happens with mortgage servicing contracts.  

Mortgage payments are made directly to the mortgage servicer. The servicer is then required to remit the payments to the mortgagee (or the investors in the mortgagee), but the servicer is entitled with retain certain funds as compensation, rather than remitting them.  In particular, servicing contracts typically compensate the servicer in three ways.

First, the servicer gets a servicing fee.  That servicing fee is calculated as a percentage of the outstanding principal balance of the loans serviced:  it's interest, typically 0.125%-0.5% of the interest payments on the loan get retained by the service.  So a slice of the interest paid on the mortgage is assigned to the servicer.  That's just as if the servicer were given a percentage of the proceeds of Blackacre.  

Second, the servicer is entitled to keep the "float" on the mortgage payments. The borrower pays the servicer on the 1st of the month, but the servicer might not be required to remit the funds to the mortgagee until the 25th of the month.  During the interim, the servicer gets to use the funds.  There are restrictions on how the servicer can use the funds, but basically, the servicer is given a rental of 300 days of mortgage payments a year, just as if it rented Blackacre for those 300 days.  Put together with the servicing fee, the servicer has the usefructs of the mortgage--it has the right to use it and to enjoy the profits. That's a real property right.  

Third, the service is entitled to keep any ancillary fees it collects. The mortgage note will itself specify the payment of late fees.  In most cases, servicers are entitled to retain all late fees. That's like getting the mineral rights to Blackacre. If the borrower doesn't pay the late fees, the servicer can sue for them, and the servicer should not be suing in the name of the mortgagee as the mortgagee has assigned all rights to the late fees to the servicer.  Same with reasonable attorneys' fees as provided for by the note, which the servicer recovers, rather than the mortgagee, assuming the servicer has engaged the attorney. 

Notice that all of this is a plain old property rights analysis of who gets what part of the mortgage note. It's totally missed by courts in a lot of opinions.  (In fairness, the fault might not be with the courts, but with the plaintiffs' attorneys for failing to understanding the privity case themselves. And there are also some opinions that either find some sort of equitable privity or which simply don't address the issue, but have rulings that are premised on privity.) This sort of contractual privity based on assignment is all separate from the privity created by a servicer's duties, such as property allocation of payments, or a servicer's activities, such as actually taking and collecting the borrower's check, determining the borrower's monthly payments (if there is an escrow required) and payoff amount, and being the point of contact with the borrower.  

Why does this privity matter?  It suggests that a borrower (or a class) has standing to challenge a servicer on breach of contract grounds for things such as unreasonable attorneys' fees, improper payment application.  It might also open the door for borrowers to sue servicers over loan modifications (or lack thereof) on the grounds of an implied duty of good faith and fair dealing.  By virtue of being the loan's partial assignee, the servicer picks up the obligations of the original lender, so there's no need to litigate over what duties the servicer owes as an agent of the noteholder. 

Comments

Bundle of sticks? Huh-kay. Freely detachable bundle of sticks? Fiddlesticks! Numerus clausus.

Numerus clausus lives at the North Pole and visits my house every Christmas.

Seriously, the Numerus clausus principle applies to estates in real property. Contract rights get split any which way, and the "estates" thus created are enforced without a second thought.

Just so, Adam. Modern finance depends on the ability to slice and dice an instrument. But I frankly think courts are using any excuse to avoid the merits of these cases. I decided to start challenging stay relief motions on standing grounds because the mortgages were assigned to the trust far too late, and the assignments should therefore be void under New York law (a choice of law provision deliberately included to protect the trust's REMIC status). I chose this tack because federal courts are obligated to pay attention to standing, and the moving party has the burden of proof. The courts have refused to accept this, though, and have even conflated the bank's prima facie claim validity arguments as satisfying the standing requirements, even though the SCOTUS has repeatedly held they are separate issues. And of course my clients don't have the resources to appeal.

But...but...that would mean the courts would have to follow the LAW...

And that would violate their cardinal rule: STLG (screw the little guy).

Contract rights can be split any way? Please try enforcing a partial assignment of a debt. Or try finding a clean opinion on a loan participation.

That doesn't sound like privity of contract or an assignment of contract rights. It does, however, sound like the servicer can be liable as the owner's agent. The law of agency permits this; it's sort of the invers of vicarious liability. Anyway, take a look at the restatement of agency.

Amos--there's an agency argument; the servicer is certainly the economic agent of the noteholder. But the servicer's compensation is the assignment of part of the note. That creates direct privity.

Adam

Is there any chance of proving that there was/is no actual default to the plaintiff trust because of the servicer advances to the trust. And if so, would that then make the servicer advances unsecured debt payable to the servicer only?

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