Suspended Animation – Suspended HELOC Accounts and Animated Borrowers

Speakers: Jonathan D. Jaffe, Partner

Steven M. Kaplan, Partner

Phoebe S. Winder, Partner

Audio Access: 1-888-422-7124 Access Code: 897200

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Speakers

Jonathan D. Jaffe, PartnerSan Francisco Office jonathan.jaffe@klgates.com415.249.1023

Steven M. Kaplan, PartnerWashington, DC Office steven.kaplan@klgates.com

202.778.9204

Phoebe S. Winder, PartnerBoston Office phoebe.winder@klgates.com617.261.3196

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Today’s webinar topics include:

How do TILA, ECOA and other consumer credit laws regulate the termination, suspension, and reduction of HELOCs?

What should a creditor consider when terminating HELOCs, or suspending or reducing draw rights?

An update on recent HELOC litigation, including the claims that have been asserted and the relief sought.

Practical thoughts on responding to HELOC complaints and preventative measures to avoid them.

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Webinar Start Time

Login open at 1:50 pm EDT Presentation begins at 2:00 pm EDT Questions from Audience at 2:50 pm EDT

Please submit your questions via the CHAT option in your Webex browser.

Audio Access: 1-888-422-7124 Access Code: 897200

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Have You Heard?

K&L Gates Launches Global Financial Markets Group. K&L Gates Adds to its European Operations with the Launch

of a Frankfurt Office. K&L Gates and Bell, Boyd & Lloyd Partners Combined Firms

on March 1. As a result of the combination of K&L Gates and Bell, Boyd &

Lloyd, K&L Gates has more than 200 lawyers in Chicago.

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Did You Know?

K&L Gates litigators have defended more than 100 consumer credit/mortgage banking class actions filed in state and federal courts throughout the country.

K&L Gates has offices in San Francisco, Palo Alto, Los Angeles, Orange County, and now - San Diego.

K&L Gates has the capability to handle loan-level litigation in many states throughout the U.S.

SUSPENDED ANIMATION:SUSPENDED HELOC ACCOUNTS

ANDANIMATED BORROWERS

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Introduction

Property values are depreciating and unemployment/underemployment are nearing historical highs.

Default rates are increasing, with the most significant impact in terms of loss severity being second lien loans.

Most HELOCs are in second lien position, with many of them now having little to no equity.

To mitigate their losses, almost every HELOC investor has undertaken efforts to either terminate the borrower’s draw privileges or to freeze/reduce the HELOC.

These efforts protect the borrower as well as the investor. But when terminating or freezing, there are a number of regulatory

requirements and limitations the investors must follow.

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Terminating HELOCs - General

Creditors are generally prohibited from terminating a HELOC and accelerating payment of the outstanding balance before the scheduled expiration of a HELOC, except when: 1. There is fraud or material misrepresentation by the

consumer in connection with the HELOC.2. The consumer’s failure to meet repayment terms for any

outstanding balance.3. Consumer’s action or inaction adversely affects the

creditor’s security for the HELOC, or any right of the creditor in the security.

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Terminating HELOCs – General - Cont.

If an event permitting termination and acceleration occurs, a creditor may instead take actions short of terminating and accelerating.

For example, a creditor may temporarily or permanently suspend further advances, reduce the credit limit, change the payment terms, or require the consumer to pay a fee. We’ll discuss this later.

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Terminating HELOCs - Fraud or Material Misrepresentation Exception – Cont.

Fraud or misrepresentation exception – Borrower fraud at any time, either during the application process or during the draw period and any repayment period.

Fraud or misrepresentation determined by applicable state law; may include acts of omission as well as overt acts, as long as any necessary intent on the part of the consumer exists.

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Terminating HELOCs - Failure to Meet Repayment Terms Exception

Creditors may terminate a HELOC and accelerate the balance when the consumer fails to meet the repayment terms provided for in the agreement.

However, this doesn’t relieve the creditor from right-to-cure notice obligations that might exist under state law.

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Terminating HELOCs - Failure to Meet Repayment Terms Exception – Cont.

Implicit is that the agreement will control. Thus, creditors should review the pertinent HELOC agreement to ensure it provides the right to terminate.

We have seen HELOC agreements that contain provisions that undercut the creditor’s right to terminate: Payment default does not arise until the creditor has given the

borrower notice of the default. No right to terminate until the borrower fails to make two or

more payments when due.

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Terminating HELOCs - Impairment of Security Exception A creditor may terminate a HELOC and accelerate the balance if

the consumer’s action or inaction adversely affects the property securing the HELOC, or any right of the investor in that security.

Examples from the Commentary The consumer transfers title to the property or sells the property without

permission; The consumer fails to maintain required insurance on the dwelling; The consumer fails to pay taxes on the property; The consumer permits the filing of a lien senior to that held by the

creditor; The sole consumer obligated on the HELOC dies; The property is taken through eminent domain; or A prior lienholder forecloses.

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Terminating HELOCs - Impairment of Security Exception – Cont. More examples from the Commentary

Filing of a judgment against the consumer and amount of judgment and collateral subject to judgment adversely affects the creditor’s collateral.

Borrower commits waste or otherwise destructively uses or fails to maintain the property, provided that action adversely affects the security.

The borrower’s illegal use of the property, provided that the illegal use subjects the property to seizure.

If one of two consumers obligated on a HELOC dies, but only if the security is adversely affected as a result.

The consumer moves out of the dwelling that secures the HELOC, provided that action adversely affects the security.

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Terminating HELOCs - Impairment of Security Exception – Cont.

Neither Regulation Z nor the Commentary defines “adversely affects.” Likely to require a fact specific determination. An action or inaction arguably adversely affects a

security property if it causes the value of the security property to decrease or otherwise impairs the creditor’s right to foreclose on the property and enforce the lien.

Arson or waste is an easy example. Non-owner occupancy is less certain.

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Suspending or Reducing Draw Privileges - General

A creditor may prohibit additional extensions of credit or reduce the credit limit applicable to a HELOC during any period in which: The value of the dwelling declines significantly below the

dwelling's appraised value for purposes of the HELOC; The creditor reasonably believes that the consumer will be

unable to fulfill the repayment obligations under the HELOC because of a material change in the consumer's financial circumstances;

The consumer is in default of any material obligation under the agreement;

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Suspending Draw Privileges – General – Cont.

The creditor is precluded by government action from imposing the annual percentage rate provided for in the agreement;

The borrower requests the suspension; The priority of the creditor’s security interest is adversely

affected by government action to the extent that the value of the security interest is less than 120 percent of the credit line;

The creditor is notified by its regulatory agency that continued advances constitute an unsafe and unsound practice; or

The maximum APR is reached, provided the creditor contractually reserved the right to refuse to make additional extensions of credit and to reduce the credit limit in this instance.

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Suspending Draw Privileges – General – Cont.

If the creditor is permitted to terminate the line and accelerate the balance, the creditor may take the lesser actions of prohibiting additional extensions and reducing the credit limit.

The creditor may not reduce the credit limit below the amount of the outstanding balance if this would require the consumer to make a higher payment.

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Suspending Draw Privileges – Significant Decline in Value

A creditor may suspend or reduce draw rights if the value of the dwelling that secures the HELOC declines significantly below the dwelling's appraised value for purposes of the HELOC.

What constitutes a significant decline for purposes of suspending the borrower’s HELOC will vary according to individual circumstances.

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Suspending Draw Privileges – Significant Decline in Value – Cont.

Safe harbor in Regulation Z permits suspension or reduction when the value declines such that the initial difference between the credit limit and the available equity (based on the property’s appraised value for purposes of the HELOC) is reduced by 50%.

So safe harbor really looks at available equity versus absolute changes in real property value.

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Suspending Draw Privileges – Significant Decline in Value – Cont.

Regulation Z and the Commentary provide that a creditor is not required to obtain an appraisal to determine value. Thus, an accurate AVM or BPO should suffice. Risk of being challenged, but could also challenge

appraisals.

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Suspending Draw Privileges – Material Change in Financial Circumstances

Commentary establishes two conditions before a creditor may suspend a HELOC as a result of a material change in the borrower’s financial circumstances. The consumer’s financial circumstances must have

materially changed. The creditor must reasonably believe that, as a result

of this change, the consumer will be unable to fulfill the payment obligations under the plan. 

Both tests met if Borrower files BK. 

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Suspending Draw Privileges – Material Change in Financial Circumstances – Cont.

For first part of the test – a material change in the consumer’s financial circumstances - Commentary offers the single example of a significant decrease in the consumer’s income. 

What is “significant”? Creditors have used FICO Scores and increased

debt as bases. Some look at debt-to-income ratio (“DTI”).

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Suspending Draw Privileges – Material Change in Financial Circumstances – Cont.

As to the second part of the test - reasonable belief that, as a result of a material change in the borrower’s financial circumstances, the consumer will be unable to fulfill the payment obligations under the plan - Commentary specifically states that a failure of the consumer to pay other debts may be evidence.

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Suspending Draw Privileges – Default of a Material Obligation

Commentary permits creditors to “specify” in the HELOC agreement events that qualify as a material obligation. If the consumer moves out of the dwelling. If the consumer permits an intervening lien to be filed

that would take priority over future advances made under the HELOC.

If the consumer fails to provide financial information requested under the HELOC contract - arguably could be considered a material obligation

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Suspending Draw Privileges – Default of a Material Obligation – Cont.

Right to define what constitutes a material default is not without limit. Commentary states that a creditor may not include

any "triggering events" or responses that Regulation Z expressly addresses in a manner different from that provided in Regulation Z.

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Suspending Draw Privileges – Notification of Suspension or Reduction in Credit Limit

Creditor must mail or deliver written notice of the action to each consumer who will be affected.

The notice need not be given in advance, but must be provided not later than three business days after the action is taken and must contain specific reasons for the action.

Creditor should review the HELOC agreement to determine whether it establishes a different, more consumer-friendly notice.

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Suspending Draw Privileges – Notification of Suspension or Reduction in Credit Limit – Cont.

Neither Regulation Z nor Commentary specifies how "specific" the creditor must be in the notice. Given the lack of guidance, a reasonable argument

can be made that more generic language will satisfy Regulation Z's "specific reasons" requirement.

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Suspending Draw Privileges – Reinstatement of Credit Privileges

Any suspension must be temporary, which means a creditor may suspend the account only during the period during which the borrower is in breach of the obligation.

When the circumstance justifying the creditor’s action ceases to exist, credit privileges must be reinstated, assuming that no other circumstance permitting such action exists at that time.

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Suspending Draw Privileges – Reinstatement of Credit Privileges – Cont.

The creditor is responsible for ensuring that credit privileges are restored as soon as reasonably possible.

The creditor may meet this responsibility in one of two ways. It can monitor the line on an ongoing basis to determine when

the condition ceases to exist. If the creditor chooses this option, it must investigate the condition

frequently enough to assure itself that the condition permitting the freeze continues to exist.

The frequency depends upon the specific condition permitting the freeze.

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Suspending Draw Privileges – Reinstatement of Credit Privileges – Cont.

Alternatively, the creditor may shift the duty to the consumer to request reinstatement of credit privileges by notifying the borrower when the creditor informs the borrower about the suspension. The creditor may require a reinstatement request to be in

writing if it notifies the consumer of this requirement. Once the consumer requests reinstatement, the creditor

must promptly investigate to determine whether the condition allowing the freeze continues to exist.

Under this alternative, the creditor has a duty to investigate only upon the consumer’s reinstatement request.

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Suspending Draw Privileges – ECOA Adverse Action

ECOA is one issue some creditors fail to recognize. Is a refusal to reinstate a borrower’s draw privileges under a

HELOC an adverse action? Except in certain limited circumstances, ECOA requires a

“creditor” to disclose certain information when taking “adverse action” against a consumer in connection with an “application” for an “extension of credit.”

If a consumer’s request to unfreeze a HELOC is deemed to be an application for an extension of credit, a refusal to grant the request may be an “adverse action” for purposes of ECOA.

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Suspending Draw Privileges – ECOA Adverse Action

An “extension of credit” is “the granting of credit in any form.” The right to draw on the HELOC is “credit” because the borrower has the right to “incur debt and defer its payment.”

Arguably, a creditor is not “granting” this right when it unfreezes the HELOC.

The term “granting” is not defined by ECOA, Regulation B or the Commentary.

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Suspending Draw Privileges – FCRA Adverse Action

FCRA also imposes disclosure requirements in connection with “adverse actions” based on information in a consumer report.

FCRA defines “adverse action” more broadly than ECOA to include (i) any action that would be an “adverse action” under ECOA; (ii) any action taken or determination made in connection with an application or transaction initiated by the consumer that is adverse to the interests of the consumer; and (iii) any action taken in connection with a review of an account to determine whether the consumer continues to meet the terms of the account, and which is adverse to the interests of the consumer.

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Suspending Draw Privileges – Fair Lending

Fair Housing Act and ECOA Disparate Treatment Unlikely Disparate Impact

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Suspending Draw Privileges – RESPA Qualified Written Requests

Creditors may receive a qualified written request (“QWR”) under RESPA as a prelude to a HELOC complaint.

We have seen QWRs that exceed 20 pages, with most of the requests not being subject to RESPA’s QWR requirements.

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Customer Complaints

Many creditors that have terminated, suspended, or reduced borrowers’ draw privileges on HELOC accounts have seen an up-tick in customer complaints.

Cases have been filed across the country – some of them class actions – that seem to provide evidence of an emerging litigation trend.

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Customer Complaints – Cont.

Generally, customers’ complaints center around the following allegations: The AVM used to support the decision to suspend a borrower’s

HELOC is inaccurate and is contradicted by an appraisal; The AVM’s reliance on neighborhood data does not provide a

representative value for the particular property; The creditor failed to provide the required notice under

Regulation Z; The suspension of the borrower’s HELOC constitutes a breach

of contract; The suspension of the borrower’s HELOC violates state unfair

and deceptive practices acts; and/or The suspension of the borrower’s HELOC constitutes fraud

under state common law.

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Creditors’ Available Defenses Borrowers Misunderstand Law. Borrowers’ complaints demonstrate that

borrowers misunderstand application of TILA and Regulation Z. Use of AVM. Regulation Z does not forbid the use of AVMs to determine

whether to suspend or terminate a HELOC. Detrimental Reliance Required. Under TILA, consumer must show

detrimental reliance in order to obtain actual damages. Preemption. State common law claims may be unavailable to expand TILA

and Regulation Z and to impose remedies that are not provided for within the regulatory framework of the statute.

Fraud. Fraud claim would require proof that creditor intended to terminate at the time it extended the HELOC to the borrower. Borrower fraud may provide independent basis for acceleration of HELOC.

Statute of Limitations. Under TILA, any action for damages must be commenced “within one year from the date of the occurrence of the violation.”

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HELOC Class Actions

Seek certification of nationwide class of borrowers who received notice that their HELOCs were reduced because of declining home values in their area.

Assert claims for, among other things: Violation of TILA and Regulation Z; Unjust enrichment; Breach of contract; State unfair and deceptive practices acts; Breach of implied covenant of good faith and fair dealing;

and Fraudulent concealment.

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Defenses to Class Certification

The Commentary to Regulation Z provides, in part, that “[w]hat constitutes a significant decline for purposes of § 226.5b(f)(3)(vi)(A) will vary according to individual circumstances.”

Individual issues include disparities among neighborhood property values, varying LTV ratios, and variations in loan documents executed by the borrowers.

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Defenses to Class Certification – Cont.

Lack of Typicality: Whether named plaintiff’s property did in fact suffer

significant decline in value in terms of the HELOC; Whether named plaintiff requested reinstatement

prior to filing suit; Accuracy of named plaintiff’s AVM is confirmed by

later appraisal made “as of” the date of the AVM; and Named plaintiff’s individual financial situation and

sophistication.

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Potential Damages

Plaintiffs in HELOC actions are likely to seek an array of damages, typically in connection with the following four claims:1. TILA

2. Breach of Contract

3. State Unfair and Deceptive Practices Acts

4. Fraud/Misrepresentation

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Potential Damages - TILA

Under TILA, if creditor suspends or terminates a HELOC improperly, creditor may be found liable for borrower’s actual damages, statutory damages, and attorney’s fees.

To recover actual damages borrower must demonstrate reliance on access to HELOC, e.g., for medical expenses, college tuition, etc. Actual damages may be difficult to prove.

Borrowers more likely to seek statutory damages In an individual action measure of statutory damages is an

amount equal to twice the finance charge of not less than $100 and up to $1,000 per loan.

In a class action damages are capped at the lesser of $500,000 or 1% of creditor’s net worth.

Rescission unavailable for HELOC suspensions / terminations / reductions.

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Potential Damages – Breach of Contract

Expectation Damages: Likely measured by 1. the difference between the interest rate on the customer’s

original HELOC agreement and the rate at which the customer obtains alternate financing, assuming the alternate rate is higher; and

2. closing costs associated with customer securing a replacement HELOC.

Consequential Damages: Likely measured by 1. the alleged impact on credit rating as a result of the termination

or modification of HELOC; and 2. the borrower’s inability to access HELOC for necessary,

immediate expenditures such as home repair projects, college tuition, etc.

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Potential Damages – UDAP Statutes

Restitution: Some UDAP statutes, notably section 17200 of the California Business and Professions Code, provide for restitution damages only.

Actual Damages: Some state UDAP statutes provide for the recovery of actual damages. And some states permit the recovery of emotional distress damages as part of an award of actual damages.

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Potential Damages – Fraud

Some cases have held, in the TILA context, that a court may award exemplary damages for fraud that is perpetrated as an incident to a breach of contract.

Creditor’s damages defenses include the economic loss doctrine.

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Pointers on Mitigating Customer Complaints

Review HELOC agreements Does the agreement prohibit or limit the action?

Exercise care in drafting of termination/suspension letters.

If using AVMs, consider which AVM vendor or alternative valuation methods

If using drop in FICO scores, consider layering, e.g., percentage of drop, absolute drop, your current FICO score limitations.

Customer service can make a difference

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Thank You

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Speakers

Jonathan D. Jaffe, PartnerSan Francisco Office jonathan.jaffe@klgates.com415.249.1023

Steven M. Kaplan, PartnerWashington, DC Office steven.kaplan@klgates.com

202.778.9204

Phoebe S. Winder, PartnerBoston Office phoebe.winder@klgates.com617.261.3196