New Year, New Article 12 of the Uniform Commercial Code The Coin of the Realm-less: Who Owns the FTX Coin? CFPB Issues Proposed Rule to Establish Public Registry of Supervised Nonbank Form Contract Provisions That Waive or Limit Consumers’ Legal Protections Moving to Address Appraisal Bias, Agencies and the Appraisal Foundation Issue Updates New York Foreclosure Abuse Prevention Act Curtails Servicers’ Options The Last Days of LIBOR State Commercial Loan Disclosure Requirements CLOs and the SOFR Transition Looking Ahead: Delaware Statutory Trusts and Finding Flexibility in Workout Situations FEBRUARY 2023
STRUCTURED FINANCE SPECTRUM | 1 Editor’s Note We are two months into the new year, and so far 2023 is proving to be as elusive to predict as its predecessors. The structured finance markets are in flux, both bringing new regulations (Article 12 of the UCC) and saying final farewell to others (LIBOR). This edition highlights some of the issues we’re facing right now, with a bit of prognosticating about what might come. I hope you enjoy the issue—and look forward to seeing many of you in Vegas! Katrina Llanes Partner, Finance Introducing... In January, we welcomed Steve Blevit, Solmaz Kraus, and Chris Juarez to the Structured & Warehouse Finance Team in Los Angeles. Over the last decade, this team has handled more than$100billionof transactions involvingsingle-family residential homes, including termandwarehouse financings and securitizations, the first institutional warehouse facility for single-family rental in 2012, the first securitization of single-family rental debt in 2013, and the first securitization of iBuyer debt in 2021. Steve also developed the financing and securitization documentation widely used at all levels of single-family rental finance today.
In 2022, the American Law Institute (ALI) and the Uniform Law Commission (ULC) approved the Uniform Commercial Code Amendments (2022) that propose changes to the Uniform Commercial Code (UCC) to address transactions in digital assets and other emerging technologies, including virtual currencies and ledger technologies. The 2022 amendments include a new article—Article 12—that expressly governs the transfer of property rights in certain digital assets or “controllable electronic records”that have been created or may be created in the future. Article 12 also leverages the use of new technologies, including virtual (non-fiat) currencies and nonfungible tokens (NFTs). The 2022 amendments include revisions to other articles of the UCC, including most notably Article 9, to facilitate incorporation of market changes arising from these new technologies. Amending the UCC Framework to Address Certain Digital Assets and Other Emerging Technologies Work on the 2022 amendments began in 2019, when ALI and ULC formed a joint drafting committee to examine the UCC and propose revisions to address emerged and emerging NewYear, New Article 12 of the Uniform Commercial Code technological developments. For 30 months, before preparing the 2022 amendments, the committee held 18 meetings with industry stakeholders, the UCC, and digital asset experts from law schools, law firms, government agencies, and private technology companies. The committee focused on the UCC’s coverage of digital assets, including controllable electronic records (CERs), chattel paper, hybrid transactions combining the sale or lease of goods with a transaction in other property outside the UCC’s scope, payment systems, and consumer issues. New Article 12 The drafting committee adopted Article 12 specifically to clarify rights in CERs, which are records stored in an electronic medium that are susceptible to control under Section 12-105. The 2022 amendments take a broad, technologically flexible approach to defining CERs but obviously contemplate CERs that arise under electronic ledger technology, such as blockchain. This electronic ledger technology assigns economic value to electronic records without intrinsic value (such as virtual currency or NFTs), and the creation or transfer of electronic records facilitates the transfer of the rights to
STRUCTURED FINANCE SPECTRUM | 3 payment, personal/real property, and the performance of services or other obligations. Before the 2022 amendments, the rights to, and perfection and priority of, certain new classes of digital assets were not clearly or optimally reflected under commercial law. Article 12 is designed to address this lack of clarity for electronic records that are “controllable” and to specify the rights acquired by a purchaser. To be controllable under Article 12-105, the following must be true of the electronic record: The electronic record must have some value or benefit (for example, a virtual currency’s “value”), and the controlling person must have the right to enjoy “substantially all the benefit.” The controlling person must have the exclusive power to prevent others from enjoying any rights or benefits of the electronic record. The controlling person must have the exclusive power to transfer control of the electronic record. The electronic record must contain some marking or other identification that a controlling person can use to readily identify themselves as having the powers listed in the three points above. The exclusivity noted in the second and third points is not voided by a party sharing the rights with another party because the electronic record is subject to certain system terms or protocols limiting the use of the record or relating to the transfer or loss of control. CERs often have rights connected, or “tethered,” to other assets, and it is the underlying asset tethered in the record, not the record itself, that provides value. Legal rights related to this underlying asset (that is, laws other than the UCC) will govern the rights to the asset and the related CER. For example, if the asset tethered to the CER relates to real property, then laws governing real property would determine the transfer of the CER tethered to that interest. An exception exists for controllable payment intangibles and controllable accounts when a person obtains control of the controllable account or controllable payment intangible and control of the tethered CER.
In addition, Article 12 provides purchasers of CERs with certain benefits of the “take-free” rule if the purchaser is a “qualifying purchaser.” “Take-free” rules permit the purchaser to acquire an interest in the transferred CER free from any competing property claims. To be a “qualifying purchaser,” the purchaser must obtain control of the CER for value in good faith and without notice of a property claim to the CER. The filing of a financing statement is not notice of a claim of property right to the CER. By applying this concept to a controllable account or controllable payment intangible, Article 12 effectively creates an electronic instrument. And so far as the terms of the controllable account or controllable payment intangible provide that the account debtor will not assert claims or defenses against the transferee of the CER, the controllable account or controllable payment intangible is effectively an electronic negotiable instrument. Article 12 expressly excludes certain electronic records from the CER definition, including deposit accounts, investment property, and an electronic copy of a record evidencing chattel paper. Generally, the drafting committee wanted to retain the outstanding law related to these assets (including Article 12 expressly excludes certain electronic records from the CER definition, including deposit accounts, investment property, and an electronic copy of a record evidencing chattel paper. rights under other articles of the UCC) and revise them to meet the challenges of the emerging market technology. The amendments on security interest, including its relation to chattel paper, are found in the 2022 amendments’ sections on Article 9. Now that the 2022 amendments have been finalized, states can facilitate their adoption. The state legislatures’ legal staff and the state and local bar associations’ legislative committees can work together to review the proposed 2022 amendments and make revisions deemed necessary to deal with state and local issues. As of February 2023, 20 states and the District of Columbia have introduced bills to adopt the 2022 amendments. It is important to note that finance market participants that do not participate in commercial transactions that involve digital assets may be impacted by the 2022 amendments due to the extensive revisions to Article 9, including the sections on paper and electronic chattel paper. n
STRUCTURED FINANCE SPECTRUM | 5 When FTX filed for bankruptcy on November 11, 2022, some compared the event to the collapse of Lehman. Among the issues in the FTX case is who owns the cryptocurrency held at—or absconded from or absconded and returned to—the FTX entities now in bankruptcy. What is property of the estate under Section 541 of the United States Bankruptcy Code is a matter of state or other applicable law, not federal bankruptcy law. This, it turns out, is a surprisingly complex question. Crypto Generally Historically, money was specie coin and fiat currency, and its value derived from its inherent substance (e.g., gold, silver, etc.), its convertibility (e.g., a gold standard), and what you could purchase with it (e.g., dollars are legal tender for purchases where dollars are accepted, which is mandated by fiat in the United States). Monetary systems rely on multipliers such as banking systems, which manage most payment processing. Cryptocurrency arrived in 2008 with a paper, Bitcoin: A Peer-to-Peer Electronic Cash System by Satoshi Nakamoto. The blockchain-enabled decentralized “distributed ledger,” Nakamoto said, would delink currency from a “trust based model” of regulated financial institutions and offer a transaction scheme with no intervening third parties to reverse The Coin of the Realm-less: Who Owns the FTX Coin? transactions. Realm-less money, with no intrinsic substance, convertibility, or fiat, was born. Cryptocurrency value would be based on its designed scarcity, independence from the trust based model, and the irreversibility of its transactions. Cryptocurrency also became valued based on speculative opinions. Bubbles are as indifferent to asset class as tulip bulbs in the mid-1600s. Cryptocurrency is controlled by numeric keys. To acquire cryptocurrency a person obtains a private key, a random number, reduced to an alphanumeric representation of the number in a high base, like radix 58 (in the case of Bitcoin). The private key is encrypted through a one-way process into a public key and a public address for the distributed ledger. “One-way process” means it is impossible to decrypt the private key from the public key or public ledger address. Whoever knows the private key controls the transfer of the coin under the related public address to another public address on the distributed ledger. To transact in the cryptocurrency, a person who knows the private key for a public address may deliver the coin under that public address to any public address controlled by a transferee. The transaction is then verified by the blockchain through a process commonly referred to as“mining.”
The Revenge of the Trust Model Black’s Law Dictionary defines “property” as “[t]hat which is peculiar or proper to any person; that which belongs exclusively to one.”The term is said to “extend to every species of valuable right or interest.” A key component of ownership is possession. While the law is unsettled, we can say with tolerable confidence that cryptocurrency is “possessed” by direct or indirect and, broadly speaking, exclusive control of an alphanumeric private key through which a public address on the distributed ledger can be manipulated to transmit coin to another public address on the distributed ledger. If a private key is lost, all cryptocurrency recorded on the distributed ledger under the public address corresponding to a private key is effectively lost forever. It can never be transacted with again, as there is no way to discover or reconstruct the private key. Thus, ownership of cryptocurrency orbits about or is always in some way derivative of control over—by agreement or otherwise—the custody of private keys. This is as unsimple as it is unsettled. A private key can be held in personal custody. This is known as “cold storage.” Cold storage can be achieved in a large number of imaginable ways. A person might store the private key on a thumb drive. A person might write the private key on a piece of paper. One could even tattoo a private key, or an encrypted private key for safekeeping, on one’s body like a treasure map. Cold storage has issues too obvious to recount. You could lose the piece of paper, lose the thumb drive, or lose the password to access the thumb drive. To address this, the practice of establishing custody wallets arose. In a rudimentary custody wallet arrangement, a thirdparty custodian is given the alphanumeric private key, for safekeeping, under rules established by the terms of a custody account agreement. In a more complex custody wallet arrangement, one or more private keys known only to the custodian might be used to hold custodial cryptocurrency on a commingled basis; i.e., the cryptocurrency is held under one or more public addresses controlled by a custodian for the benefit of multiple owners. For the rudimentary and more complex arrangements to be secure, several things are needed. The custody account terms must be clear and unambiguous. Compliance by the custodian with the terms of the custody agreement is essential. The custodian must not make unauthorized transactions with the private key. The nature of cryptocurrency, particularly the inability to discover the private key, and thus a private key holder, heightens the need for integrity. Often custody accounts are insured to indemnify against the loss of the private keys. For an insurer to insure, its underwriting will require integrity of compliance and risk management. You can see here that even with a custody wallet the “trust based model” creeps back in. There is another wrinkle. The Nakamoto paper stated that “[t]he cost of mediation [in the trust based model] increases transaction costs.”But because of the means of its transmission on the distributed ledger, cryptocurrency comes with a high transaction cost; two transaction parties having control over a private key and related public keys and addresses have to be matched. This is where exchanges, like FTX, come in. By establishing a common pool of cryptocurrency and fiat cash, it is possible to transact efficiently in cryptocurrencies. Cryptocurrency is maintained at the exchange through one or more private keys known only to the exchange, and cash is maintained through various bank accounts. The customer transmits cash or cryptocurrency to the exchange and receives a customer account, which is essentially an internal ledger entry at the exchange. This is similar to a bank account. If a private key is lost, all cryptocurrency recorded on the distributed ledger under the public address corresponding to a private key is effectively lost forever.
STRUCTURED FINANCE SPECTRUM | 7 Account holders may then exchange their cryptocurrency and cash using the internal ledger of the exchange. The only actual transfers recorded in the distributed ledger, as opposed to the internal ledger of the exchange, are done periodically after netting all the internal transactions and withdrawals of cryptocurrency and cash from the exchange. This dramatically reduces the cost of the cryptocurrency transactions. It also resurrects the “trust based model” that Nakamoto had sought to kill. A traditional “trust based model” works through internal controls, extensive and redundant risk management layering, regulation, fear of law enforcement, and in the case of unregulated capital, by limiting investment to a small number of investors who are not accredited investors. For everyone else, there are banks and insurance companies, highly regulated entities. FTX Meltdown: Who Owns What of What’s Left When close to all of the FTX entities filed for bankruptcy in early November, the filing entities had approximately 330 employees, of which approximately 127 were located in the United States. These employees were responsible for the risk management and internal controls of over 90 entities, tens of billions of assets and liabilities, and more than 1 million individual accounts. This is farcically inadequate to provide appropriate risk management. According to the first-day declaration of John Ray III, chief restructuring officer and CEO of FTX, “Never in my career have I seen such a complete failure of corporate controls.” Sam Bankman-Fried’s “effective altruism” model gave way to a “trust based model”meltdown. Now FTX account holders are waiting to discover what they own of whatever is left. There are several things to know about the process of determining ownership. One, these will be cases of first impression. There is no substantial body of precedent law to address and provide certainty to the questions of ownership. Two, the precise terms of the account agreements will be very important to the determination. Three, the law governing these agreements and the jurisdiction of the “location” of the alphanumeric keys and accounts will also be very important to the determination, because it is this local law that will determine what is or is not property of the estate under Section 541 of the Bankruptcy Code. For example, Idaho has a developed statutory scheme (House Bill 583) for the purchase and sale of digital assets and for perfection of security interests in virtual currency. Voyager and Celsius Opinions and Account Terms We have one opinion to look to in In re Voyager Digital Holdings Inc., No. 1:22-bk-10943 (Bankr. S.D.N.Y. 2022), and one to look to in In re Celsius Network, No. 1:22-bk-10964 (Bankr. S.D.N.Y. 2023). In In re Voyager Digital Holdings, Judge Michael Wiles ruled that fiat currency funds (i.e., cash) held for the benefit of (FBO) account holders at Metropolitan Commercial Bank were not property of the estate under Section 541 of the Bankruptcy Code because (1) the bank accounts were designated FBO
accounts and (2) the terms of the customer agreements of Voyager with certain Voyager account holders explicitly stated that “each Customer is a customer of the [Metropolitan Commercial Bank].” Of note is that, in addition to the clarity of the terms, no party contested the matter. Also, the ruling did not extend to cryptocurrencies held by Voyager, for which the customer agreements were unfavorable to account holders who might claim ownership of the cryptocurrency: Customer grants Voyager the right … to pledge, repledge, hypothecate, rehypothecate, sell, lend, stake, arrange for staking, or otherwise transfer or use any amount of such Cryptocurrency, separately or together with other property, with all attendant rights of ownership…. In In re Celsius Network, Judge Martin Glenn ruled on whether account holders in that case who held “earn accounts” actually owned the cryptocurrency in those accounts. The Celsius case was decided based on the unambiguous language in the customer agreement. The customer agreements stated: “you grant Celsius … all right and title to such Eligible Digital Assets [cryptocurrency], including ownership rights ….” Celsius had, among other things, the right to rehypothecate, pledge, or transfer all cryptocurrency in the “earn accounts.” Quod erat datum: The cryptocurrency is not the customers’ property. But In reCelsiusNetwork’s value as aprecedent is limitedbecause it is based on the specific language of the account agreements governing the “earn accounts.” FTX accounts are maintained under account agreements that were written by FTX lawyers and the specific language is different. However, rights to transfer, rights to rehypothecate, rights to commingle, express rights of ownership, and admonitory language that account holders may not be able to exercise rights of ownership will all be indicative of a lack of ownership, although a final determination of ownership will be based on the whole of the agreement and to the extent there is ambiguity, possibly the practices related to the account. Custody Accounts and Commingling When it comes to custody accounts when a private key is transmitted to a custodian, what rights that creates will be determined by the terms of the custody account under the governing law of that custody account agreement. If the custody account agreement terms are unambiguous that the custodian will only hold the private key and will not transact in the cryptocurrency controlled by the private key, except at the instruction of the custody account holder, then it is likely that the cryptocurrency controlled on the distributed ledger by the private key held by the custodian will be found to be the property of the custody account holder and not the property of the estate. If a custodian has agreed to aggregate custody of cryptocurrency under a public address or public addresses corresponding to a private key or private keys known only to the custodian, but has also agreed that no rehypothecation or transfers are permitted apart from the instructions of the account holders, then what? Despite commingling, this might be sufficient to establish ownership. If managed in accordance with the terms of the agreement, there would always be sufficient cryptocurrency in the custody account to return the exact number of coins deposited by each custody account holder. In addition, there are many arrangements in state law for commingled goods to create an undivided whole property Today there are few definitive answers, but the FTX case and other crypto exchange cases will start to shape a body of law that will add certainty and regulatory overlay to the world of cryptocurrency.
STRUCTURED FINANCE SPECTRUM | 9 interest in a commingled mass. “Commingling fungible goods is not categorically antithetical to a bailment,” according to In re Enron Corp., No. 01-16034 (Bankr. S.D.N.Y. Jan. 22, 2003). In cases of commingled fungible assets such as steel pellets, oil, and gas, often several owners will have an ownership interest in the form of a bailment that can be divided into lots of exclusive ownership. They create an undivided interest in a fungible mass analogous to a tenancy in common. The law generally favors flexible partition, so there is a thread of reason that would permit withdrawal and partition by one bailee or tenant, as it were, of its interest in the fungible coin under a commingled custody arrangement. Note also that the concept is embodied in the Uniform Commercial Code to address continuing liens in even irretrievably commingledcollateral. See, for example, comment 4 to Section 9-336 of the NewYork Uniform Commercial Code: SP-1 has a perfected security interest in Debtor’s eggs, which have a value of $300 and secure a debt of $400, and SP-2 has a perfected security interest in Debtor’s flour, which has a value of $500 and secures a debt of $600. Debtor uses the flour and eggs to make cakes, which have a value of $1,000. The two security interests rank equally and share in the ratio of 3:5. Applying this value to the entire value of the product, SP-1 would be entitled to $375 and SP2 would be entitled to $625. Arguably, similar rules should apply to commingled but traceable cryptocurrency custody arrangements. Hypothetically, then, if 10 custody account customers transmit equal amounts of a cryptocurrency to a single custody account managed by a single custodian with one or more private keys and corresponding public keys and addresses, under appropriate and unambiguous account terms establishing a bailment, a tenancy in common or a trust arrangement, then each account holder could, and a strong case can be made they should, own one tenth of whatever remains, and whatever is recovered to, the public addresses used for the custodial arrangement. Similar reasoning might be used to establish that a trust arrangement between the custodian and the customers has been established. In that instance, the estate under Section 541 would own the legal title to the cryptocurrency in the custody account, but not the beneficial title, the right to the value of the trust estate, which would be the property of the customers. Conclusion This leaves FTX account holders—and account holders at other distressed exchanges—with a great deal to think about. Do their account terms and the related practices suggest that a court will find that they have a property right—clear title to a defined unique alphanumeric private key, a tenancy in common in or beneficial title to one or more custodial private keys—to the underlying cryptocurrency falling outside the property of the estate under Section 541 of the Bankruptcy Code? A careful read of the account terms should tell a good part of the story. A question that follows is if indeed account holders of any particular class held a right to property in cryptocurrency and that right was converted to someone else’s use—was transacted without in violation of agreements—will the converted cryptocurrency be recovered and ultimately returned to them as the true owner? Or will good faith recipients of such cryptocurrency, to the extent they can be discovered, be sheltered from recovery. There may also be competing actions by law enforcement to pursue asset forfeitures. Will law enforcement asset forfeitures be returned to the bankruptcy estate of the FTX entities for distribution to unsecured creditors? If they are traceable to valid custody arrangements, will they be returned to the true owner? Today there are few definitive answers, but the FTX case and other crypto exchange cases will start to shape a body of law that will add certainty and regulatory overlay to the world of cryptocurrency. These cases will likely dovetail with the emergence of new regulatory schemes developed by legislatures and regulators. Despite there being no definitive answer, competent analysis can already begin to answer the questions and define risk. n
On January 11, 2023, the Consumer Financial Protection Bureau (CFPB) announced a Proposed Rule to establish a public registry and require nonbanks supervised by the agency to register their use of certain terms and conditions contained in “take it or leave it” form contracts for consumer financial products or services that “attempt to waive consumers’ legal protections, to limit how consumers enforce their rights, or to restrict consumers’ ability to file complaints or post reviews.” The purpose of Proposed Rule’s registration system is to allow the CFPB to prioritize oversight of nonbanks that use the covered terms and conditions based on the agency’s perception these provisions pose risks for consumers. The CFPB seeks public comment on the practical utility of collecting and publishing this information and ways to minimize the burden of the information collection on respondents. The comment period closes on April 3, 2023. The Proposed Rule The Proposed Rule would require annual registration by most nonbanks subject to the CFPB’s jurisdiction, with limited exceptions. Specifically, a “supervised nonbank” would be defined to mean a “nonbank covered person” that is subject to supervision and examination by the CFPB, except to the extent that the person engages in conduct or functions that are excluded from the CFPB’s supervisory authority pursuant to 12 U.S.C. 5517 or 5519. A supervised nonbank would include any nonbank covered person that (1) offers or provides a residential-mortgage-related product or service, any private educational consumer loan, or any consumer payday loan; CFPB Issues Proposed Rule to Establish Public Registry of Supervised Nonbank Form Contract Provisions That Waive or Limit Consumers’ Legal Protections
(2) is a larger participant engaged in consumer reporting, consumer debt collection, student loan servicing, international money transfers, and auto financing; or (3) is subject to a CFPB order issued pursuant to 12 U.S.C. 5514(a)(1)(C). Those excluded from the scope of the Proposed Rule would include persons subject to CFPB supervision and examination solely in the capacity of a service provider, natural persons, and persons with less than $1 million in annual receipts resulting from offering or providing all consumer financial products and services relevant to the activities noted above. Also exempt from the rule would be a person that has not, together with its affiliates, engaged in more than de minimis use of covered terms and conditions (i.e., fewer than 1,000 times in the previous calendar year) and a person that used covered terms or conditions in covered form contracts in the previous calendar year solely by entering into contracts for residential mortgages on a form made publicly available on the internet required for insurance or guarantee by a federal agency or purchase by Fannie Mae, Freddie Mac, or Ginnie Mae. Under the Proposed Rule, a “covered term or condition”would be subject to the rule’s reporting requirements. A “covered term or condition” would be defined as “any clause, term, or condition that expressly purports to establish a covered limitation on consumer legal protections applicable to the offering or provision of any consumer financial product or service.” In turn, “covered limitation on consumer legal protections” would be defined to mean any covered term or condition in a covered form contract: 1. Precluding the consumer from bringing a legal action after a certain period of time; 2. Specifying a forum or venue where a consumer must bring a legal action in court; 3. Limiting the ability of the consumer to file a legal action seeking relief for other consumers or to seek to participate in a legal action filed by others; 4. Limiting liability to the consumer in a legal action including by capping the amount of recovery or type of remedy; 5. Waiving a cause of legal action by the consumer, including by stating a person is not responsible to the consumer for a harm or violation of law; 6. Limiting the ability of the consumer to make any written, oral, or pictorial review, assessment, complaint, or other similar analysis or statement concerning the offering or provision of consumer financial products or services by the supervised registrant; 7. Waiving, whether by extinguishing or causing the consumer to relinquish or agree not to assert, any other identified consumer legal protection, including any specified right, defense, or protection afforded to the consumer under Constitutional law, a statute or regulation, or common law; or 8. Requiring that a consumer bring any type of legal action in arbitration. In the Proposed Rule, the CFPB acknowledges that there may be overlap in the types of covered terms and conditions, so some contract provisions may fall into more than one category. The Proposed Rule currently proposes to limit the collection of terms and conditions that expressly attempt to establish the covered limitation. Any contract containing a covered term would be considered a “form contract” provided it (1) was included in the original contract draft presented to the consumer; (2) was not negotiated between the parties; (3) is intended for repeated use in transactions between the company and consumers and contains a covered term or condition. STRUCTURED FINANCE SPECTRUM | 11 The Proposed Rule would require annual registration by most nonbanks subject to the CFPB’s jurisdiction, with limited exceptions.
Supervised nonbanks covered by the Proposed Rule would be required to collect and submit this information through the CFPB’s registration system. Under the Proposed Rule, the registry of terms and conditions would be publicly available, rather than limited to government regulators or CFPB staff. The CFPB supports the public availably of this data on the grounds that it will lead to more informed consumers and provide other regulators the opportunity to identify covered terms and conditions that are explicitly prohibited by the laws they enforce or supervise. The proposed format for the registry is similar to another recent CFPB proposed rule that proposes to establish a public registry of regulatory actions involving certain nonbanks subject to CFPB supervision. We discussed this proposed rule in a blog post, “CFPB Proposes Nonbank Registry to Focus on Compliance ‘Recidivism.’” CFPB’s Request for Comment on the Proposed Rule The CFPB is seeking comment on a range of issues related to the Proposed Rule, including: The prevalence of the covered terms and conditions. Potential impacts of collecting and publishing this information. Reasons why the information should not be publicly disclosed. The burden of collecting and filing these provisions. The use of form contracts purchased from third parties. Other entities that may be affected by the proposed rule. The period for public comment ends on April 3, 2023. Is the Establishment of a Public Registry Likely? The CFPB currently has 37 rules that have been proposed but not implemented, five of them since the start of the Biden Administration. Most notably, neither the CFPB’s proposed rule for small business lending data collection from September 1, 2021 or its proposed rule for credit card late fees and late payments from June 22, 2022 have been finalized. Since the substance of this rule is limited to the collection and publication of contract terms, rather than the prohibition of any behavior, enactment might be more likely. The recent Fifth Circuit decision in Community Financial Services found the CFPB’s funding structure unconstitutional and vacated the agency’s Payday Lending Rule on those grounds. Now any rule promulgated by the CFPB would likely be susceptible to legal challenges. Takeaway The CFPB’s focus on seeking public disclosure of covered terms and conditions reflects a continued focus on the content of form contracts used in nonbanks’ consumer finance products and services. The public nature of the registry could lead to increased scrutiny of contract provisions by the CFPB, other regulators, and the public, increasing reputational risk to covered entities and the likelihood of heightened enforcement activity by federal and state regulators. Entities that would be subject to the Proposed Rule’s requirements should carefully review the Proposed Rule and consider commenting. Click here to subscribe to our Consumer Finance blog. n Under the Proposed Rule, the registry of terms and conditions would be publicly available, rather than limited to government regulators or CFPB staff.
STRUCTURED FINANCE SPECTRUM | 13 A year and a half after President Biden’s announcement of the Interagency Task Force on Property Appraisal and Valuation Equity (PAVE), the past weeks have seen a flurry of activity from federal agencies and the Appraisal Foundation to address issues of bias in residential property appraisal. What should lenders, servicers, and appraisers know? Background In June 2021, President Biden announced the formation of the PAVE Task Force, comprising 13 federal agencies, including the White House Domestic Policy Council. He tasked the group with identifying and evaluating “the causes, extent, and consequences of appraisal bias and to establish a transformative set of recommendations to root out racial and ethnic bias in home valuations.” In March 2022, the member agencies of the PAVE Task Force published an action plan, announcing a series of concrete commitments to address appraisal bias in fivebroad categories: 1. Strengthening guardrails against discrimination in all stages of residential valuation. 2. Enhancing fair housing and fair lending enforcement, and driving accountability in the appraisal industry. 3. Building a diverse, well-trained, and accessible appraiser workforce. 4. Empowering consumers to take action against bias. 5. Giving researchers and enforcement agencies better data to study and monitor valuation bias. While the task force’s activity is ongoing, federal agencies in the past fewweeks have announced a series of steps that are in line with the PAVE goal of addressing real property appraisal bias. FHA: Draft Mortgagee Letter on Reconsiderations of Value and Appraisal Review On January 3, 2023, the Federal Housing Administration (FHA) published for public comment a draft mortgagee letter, Borrower Request for Review of Appraisal Results, that would permit a second appraisal tobe ordered if a direct endorsement Moving to Address Appraisal Bias, Agencies, and the Appraisal Foundation Issue Updates
underwriter determines that an original appraisal contains a material deficiency. The letter would expressly identify as a material deficiency—one that would directly impact value and marketability of the underlying property—indications of either unlawful bias in the appraisal or a violation of applicable federal, state, or local fair housing and nondiscrimination laws. Further, the draft mortgagee letter would require the underwriter in a transaction involving an FHA-insured loan to “review the appraisal and ensure that it is complete, accurate, and provides a credible analysis of the marketability and value of the Property.” Among other criteria, this would require the underwriter to make a determination of whether the appraisal is materially deficient—that is, whether the appraisal contains indications of unlawful bias or a violation of applicable fair housing and nondiscrimination laws. Providing a “credible analysis” exceeds the scope of a quality control review. If included in a finalized mortgagee letter, it would require lenders to determine whether underwriters must be statelicensed or state-certified appraisers. The draft mortgagee letter also sets forth standards for the submission and consideration of a borrower’s request for a review of appraisal results, including the submission of a reconsideration of value request to the appraiser. VA: Enhanced Oversight Procedures to Combat Appraisal Bias On January 18, the Department of Veterans Affairs (VA) issued Circular 26-23-05, detailing the enhanced oversight procedures that the VA has adopted “to identify discriminatory bias in home loan appraisals and act against participants who illegally discriminate based on race, color, national origin, religion, sex (including gender identity and sexual orientation), age, familial status, or disability.” In the circular, the VA indicated that it will review all appraisal reports submitted in connection with VA-guaranteed home loans to identify any potential discriminatory bias. The VA will: (1) conduct an escalated review of any suspected incidents of bias; and (2) remove from its panel of approved appraisers any individual who is confirmed to have provided a biased appraisal. The VA also reminded panel appraisers that in submitting a Fannie Mae Form 1004 (Uniform Residential Appraisal Report), they certify that they have not based the opinion in an appraisal report on discriminatory factors (e.g., race) of either the property applicants or the residents of the area where the property is located. Appraisal Foundation: Proposed Revision of Appraisal Standards In mid-December, the Appraisal Standards Board (ASB) of the Appraisal Foundation released its fourth exposure draft of proposed changes to the Uniform Standards of Professional Appraisal Practice (USPAP), the operational standards that govern real property appraisal practice. In response to comments received in response to the last draft, the ASB proposes to add to the USPAP Ethics Rule a section expressly discussing nondiscrimination. The proposed section would prohibit appraisers from engaging in both unethical discrimination and illegal discrimination and would provide guidance on the type of conduct constituting each form. Unethical discrimination First, the ASB proposes to include an express statement that an appraiser must not engage in unethical discrimination. That prohibition would preclude an appraiser from developing or reporting an opinion or value that is based on the actual or perceived protected characteristics of any person. Second, the rule would prohibit an appraiser from performing an assignment with bias against the actual or perceived protected characteristics of any person—meaning that the appraiser may not engage in any discriminatory conduct (regardless of whether it arises in the course of developing or reporting an opinion of value). For purposes of this prohibition, the rule would utilize the USPAP definition of bias: “a preference or inclination that precludes an appraiser’s impartiality, independence, or objectivity in an assignment.” The rule would make a limited exception for activity that qualifies with “limited permissive language,” permitting an appraiser to use or rely on a protected characteristic in an assignment only if:
STRUCTURED FINANCE SPECTRUM | 15 Laws and regulations expressly permit or otherwise allow the consideration of a protected characteristic. Use of or reliance on that characteristic is essential to the assignment and necessary for credible assignment results. Consideration of the characteristic is not based on bias, prejudice, or stereotype. The exposure draft provides as an example of activity that might qualify for the exception the completion of an appraisal review in order to determine whether the initial appraisal was discriminatory. The ASB proposal makes clear that because “an appraiser’s ethical duties are broader than the law’s prohibitions,” an appraiser may commit unethical discrimination without violating any applicable law; however, an act that “constitutes illegal discrimination … will also constitute unethical discrimination.” Illegal discrimination Complementing the prohibitions on unethical discrimination, the ASB proposes to include an express statement that an appraiser must not engage in illegal discrimination—conduct that violates the minimum standards of antidiscrimination set forth in the Fair Housing Act, the Equal Credit Opportunity Act (ECOA), and Section 1981 of the Civil Rights Act of 1866. The rule would impose on appraisers a duty to understand and comply with such laws as they apply to the appraiser and the appraiser’s assignments, including the concepts of disparate treatment and disparate impact. Further, the rule would prohibit an appraiser from using or relying on a nonprotected characteristic as a pretext to conceal the use of or reliance on protected characteristics when performing an assignment. Further guidance The exposure draft indicates that the ASB would follow the adoption of the new nondiscrimination section of the ethics rule with detailed guidance on the scope of these prohibitions, including: Background on federal, state, and local antidiscrimination laws. Guidance on the application of the Fair Housing Act, ECOA, and Section 1981 to appraisals of residential real property. Explanation of the disparate treatment and disparate impact theories of discrimination, including examples relating to appraisal practice. Guidance on neighborhood discrimination in real property appraisals. Clarification on acceptable uses of protected characteristics, in connection with the “limited permissive language” exception for the prohibition against unethical discrimination. OMB: AVM Rule on Regulatory Agenda Automated valuation models (AVMs) are considered a useful tool to help mitigate appraisal discrimination. On January 4, 2023, the Office of Management and Budget (OMB) released its Fall 2022 Regulatory Agenda. Among other topics, the OMB indicated that an interagency proposed rule addressing quality control standards for AVMs is expected in March 2023. The Dodd–Frank Act’s amendments to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) require the federal banking regulatory agencies to undertake this rulemaking. The ASB proposes to include an express statement that an appraiser must not engage in unethical discrimination.
ASC: Hearing on Appraisal Bias On January 24, 2023, the Appraisal Subcommittee (ASC) of the Federal Financial Institutions Examination Council held a hearing on appraisal bias. Of note, Consumer Financial Protection Bureau Director Rohit Chopra ended the hearing by articulating the objective that the “lodestar” of appraisals is an appraisal that is neither too high nor too low, but rather is accurate. Chopra then questioned the regulatory structure governing appraisals, calling it “byzantine.”His remarks focused on the funding mechanism between the Appraisal Institute and the Appraisal Foundation, implying that there may be a conflict of interest. Understanding Chopra’s comment requires knowledge of the current regulatory framework, which Title XI of FIRREA established in 1989. It includes three principal parties: the ASC, the Appraisal Foundation, and the Appraisal Institute: The ASC is a federal agency with oversight of the state appraisal regulatory structure for real property appraisers and monitoring activities of the Appraisal Foundation. The Appraisal Foundation is a private nonprofit educational organization. Through the ASB and the Appraiser Qualifications Board, the Appraisal Foundation sets the ethical and performance standards of appraisers in the USPAP. The board establishes the minimum education, experience, and examination requirements for real property appraisers, which are then enforced by state regulatory agencies. The Appraisal Foundation is funded through sales of publications and services, as well as by its sponsoring organizations. The Appraisal Institute is a private professional organization of appraisal professionals and is one of the sponsoring organizations of the Appraisal Foundation. Takeaway Viewed through the lens of the overall PAVE Task Force efforts, actions by the FHA and the VA show early and concrete action to address residential appraisal bias. Because they implicate government insurance and guarantee programs, the focus is particularly important for lenders and appraisers to heed so that documentation submitted to the agencies is accurate. Appraisers should also take note of the updated USPAP exposure draft as it moves toward final adoption so that they are aware of their responsibilities to avoid bias in appraisal reports. Finally, with regulators scrutinizing the appraisal framework—as seen in the OMB and ASC announcements— more significant changes are expected. Click here to subscribe to our Consumer Finance blog. n Viewed through the lens of the overall PAVE Task Force efforts, actions by the FHA and the VA show early and concrete action to address residential appraisal bias.
STRUCTURED FINANCE SPECTRUM | 17 New York Assembly Bill 7737B, the Foreclosure Abuse Prevention Act, became law on December 30, 2022. The Act is significant because it reverses judicial precedent that permitted a lender, after default, to undo the acceleration of a mortgage and stop the running of the statute of limitations in a foreclosure action through voluntary dismissal, discontinuance of foreclosure actions, or deacceleration letters. Notably, the Act applies both prospectively and to any foreclosure action filed before its effective date that had not been resolved through a final judgment and order of sale. Further, unlike other provisions of NewYork law, the Act applies to all properties (and not only those that are owner-occupied). Public reaction has been mixed whether the measure will benefit consumers—but regardless, it changes the rules of the game for lenders and servicers in New York State. Background ExistingNewYork lawestablishes a six-year statuteof limitations for the commencement of a mortgage foreclosure action, triggered when the borrower defaults on the obligation and the lender accelerates the obligation to pay the secured debt. In 2021, the New York Court of Appeals considered whether a lender can deaccelerate a loan and reset the statute of limitations. The court decided four cases (with the opinion rendered in Freedom Mortgage Corp. v. Engel, 37 N.Y.3d 1 (2021)), “each turning on the timeliness of a mortgage foreclosure claim.”The court held that the lender’s voluntary dismissal of a foreclosure suit constituted a revocation of the lender’s election to accelerate. The revocation returned the parties to their preacceleration rights, reinstated the borrower’s right to repay via installments, and established a new statute of limitations period for any future default payments. According to the court, “where the maturity of the debt has been validly accelerated by commencement of a foreclosure action, the noteholder’s voluntary withdrawal of that action revokes the election to accelerate, absent the noteholder’s contemporaneous statement to the contrary.” The court also considered what constituted an “unequivocal overt act” sufficient to trigger a valid acceleration of debt and the six-year statute of limitations. The court held that neither NewYork Foreclosure Abuse Prevention Act Curtails Servicers’Options
the issuance of a default letter nor the filing of complaints in prior discontinued foreclosure actions that failed to reference the pertinent modified loan were sufficient methods to validly accelerate debt. The Act Since the Engel decision, mortgagees in New York State have relied on their ability to voluntarily discontinue a foreclosure action—and effectively reset the statute of limitations— to engage distressed borrowers in loss mitigation efforts. However, the Act appears to eliminate a mortgagee’s ability to unilaterally reset the limitations period by voluntarily discontinuing a foreclosure action and deaccelerating the loan. With the express intent of overturning the Engel decision, the Act amends provisions of New York’s Real Property Actions and Proceedings Law (RPAPL), General Obligations Law (GOL), and Civil Practice Law and Rules (CPLR) relating to the rights of parties involved in foreclosure actions. Real Property Actions and Proceedings Law Under previous law, Section 1301 of the RPAPL prohibited the commencement or maintenance of any action to recover any part of amortgage debt while another action to recover part of the mortgage debt is already pending or after final judgment has been made for the plaintiff without leave of the court in which the first action was brought. Beyond clarifying that a foreclosure action falls within the scope of that prohibition, the Act provides that procurement of leave from the first court must be a condition precedent to commencing or maintaining the new action. Thus, failure to comply with the leave-of-courtcondition precedent may no longer be excused by finding that the prior action was “de facto discontin(ued)” or “effectively abandoned” or that the defendant was not prejudiced nor by deeming the pre-action failure a mistake, omission, defect, or irregularity that could be overlooked or disregarded. Moreover, failure to obtain leave is a defense to the new action. If a party brings a new action without leave of the court, the section declares that the previous action is deemed discontinued unless before the entry of final judgment in the original action, the defendant: (1) raises the failure to comply with the condition precedent; or (2) seeks dismissal of the action based on one of the grounds set forth in Section 3211(a)(4) of the CPLR. Section 1301 of the RPAPL is further amended to provide that if the mortgage securing the bond or note representing the debt so secured by the mortgage is adjudicated as timebarred by a court of competent jurisdiction, any other action to recover any part of the same mortgage debt is equally timebarred. As a result, if the statute of limitations acts to bar a foreclosure action or any other action to recover on mortgage debt, an investor or servicer cannot bring any other action to recover the same part of the mortgage debt, including another foreclosure action or an action to recover a personal judgment against the borrower on the note. General Obligations Law Under Section 17-105 of the GOL, an agreement to waive the statute of limitations to foreclose on a mortgage is effective if expressly set forth in writing and signed by the party to be charged. The Act amends Section 17-105 by: (1) clarifying that the GOL is the exclusivemeans by which parties are enabled to postpone, cancel, reset, toll, revive, or otherwise effectuate an extension of the limitations period for the commencement of an action or proceeding upon a mortgage instrument; (2) clarifying that unless effectuated in strict accordance with Section 17-105,
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