Banking & Finance Law Report

Legal mistakes, Good Faith Errors and the Fair Debt Collection Practices Act

Things looked bad for an Illinois law firm in 2014 when a consumer complaint was filed in federal district court against it. It was accused of violating the Fair Debt Collection Practices Act. The firm’s purported violation: Not anticipating when an appellate court would overrule established precedent.

And an opinion of United States Supreme Court overruled the firm’s best defense: that it had made a good faith legal error.

The matter began in 2013 when the law firm filed a consumer collection action. The FDCPA requires the filing of collection actions in the “judicial district” where the debtor lives or signed the contract.  The law firm reasoned that if the debtor lived in the Cook County judicial district, filing the suit would be proper there.  Its choice of venue was the First Municipal District of the Circuit Court of Cook County.

But there was a complication. There are many municipal districts in Cook County and the consumer did not actually live in the First Municipal District (although he did live in Cook County).

So should the law firm file the suit in the municipal district where the debtor lived? Or was it enough to file in the “judicial” district of Cook County?

The firm consulted its law books. It found a decision in 1996 of the federal Seventh Circuit Court of Appeals right on point.  And Cook County is in the Seventh Circuit.  That case was well known and had been followed in other cases.  That seemed to be the end of the matter until a few weeks after the filing of the collection action.

Then the Court of Appeals in a split decision overruled the older decision. The case should have been filed in the municipal district where the debtor lived.

Now it was clear that the law firm had filed the collection suit in the wrong place. The firm voluntarily dismissed the case, without prejudice to refiling in the correct venue.

And was the consumer happy? No. He turned the table on the firm and became a plaintiff under the FDCPA.

Under the FDCPA, a debt collector (in this case the law firm) is responsible for its errors. And consumers can enforce the FDCPA.

It was clear in this case, of course, there had been an error even if there was a good justification for it. But a U.S. Supreme Court decision under the FDCPA refuses to permit debt collectors to assert a good faith error defense when the error at issue is a legal mistake.  The consumer argued filing in the venue was no doubt a legal mistake.  So it didn’t matter whether the law firm acted in good faith.

The law firm argued it was unfair to impose liability against it in these circumstances. It had followed a clear judicial precedent, in good faith.  There was no dispute about that.

The law firm argued that it should not be required to predict when previous legal precedent would be overruled. If that was the case, then how would anyone know which cases to follow and which to disregard?  The Seventh Circuit Court of Appeals ultimately agreed, affirming a decision of the lower court that did not impose liability on the law firm.

Under the bona fide error defense, a debt collector is shielded from liability under the FDCPA, if it can show by preponderance of the evidence the violation was unintentional and resulted from a bona fide error notwithstanding procedures put in place to avoid the error. There was no assertion the law firm’s violation was intentional or that the law firm did not maintain procedures designed to avoid errors.

The only issue was whether the firm could rely on precedent and still be in “good faith.” At the time of the decision, the previous decision was almost eighteen years old. While the decision may have been criticized, it was clear the previous decision permitted the law firm to file the lawsuit where the lawsuit was filed.

The debtor asserted, however, that a recent U.S. Supreme Court decision, Jeremy v. Carlisle, 559 U.S. 573 (2010), held that the bona fide error defense was not intended to apply to a mistake in interpretation of legal requirements.  Debt collectors must follow the law and the good faith defense was intended by Congress to cover other kinds of errors.

But the Seventh Circuit Court of Appeals held the law firm had in fact made no mistake in legal interpretation because the existing precedent permitted the law firm to file where it did. The Court reasoned the law firm correctly interpreted the law that existed at the time the lawsuit was filed.

The Court of Appeals concluded that it was not the law firm’s mistake. Instead, it was the Court of Appeal’s mistake in its previous interpretation of the law that led to the misfiling of the collection action.

The Court of Appeals noted that the filing of the lawsuit was indeed a violation of the FDCPA. Yet that result was under the new precedent.  The retroactive change of law was entirely outside of the law firm’s control.  Hence, the bona fide error of defense applied.

The Court made specific mention of two aspects of record of the case. The Court may have found these persuasive in reaching its view of the case.

First, as soon as the older court decision was overruled, the law firm voluntarily dismissed its collection action.

Second, during the consumer’s deposition he was asked if where the collection suit was filed mattered to him. He responded, “I would say it only matters to me because it matters to my lawyer.”

Oliva v. Blatt, Hasenmiller, Leibsker & Moore, LLC, U.S. Court of Appeals, Seventh Circuit, No. 15 -2516 (June 14, 2016).

Expanding the Defense of Ordinary Course and Widening the Range of Acceptable Payments During the Historical Period

The Seventh Circuit Court of Appeals in Unsecured Creditors Committee of Sparrer Sausage Co., Inc. v. Jason’s Foods, Inc., 2016 WL 3213090 (7th Cir. June 10, 2016) expanded the scope of the ordinary course defense in a bankruptcy preference action.  This case provides an excellent road map for a creditors’ rights attorney defending a preference suit and suggests arguments for increasing the payments a creditor can retain even if those payments were made during the 90-day preference period.

Here are the facts in Jason’s Foods.  During the 90-day preference period, the debtor paid invoices it received from Jason’s Foods totaling about $587,000.00.  The Unsecured Creditors’ Committee filed suit asking the bankruptcy court to avoid all payments made within the 90-day preference period.  The bankruptcy court ruled that prior to the preference period, the debtor generally paid the invoices to Jason’s Foods within 16 to 28 days.  Accordingly, of the 23 invoices paid during the preference period, 12 were within the range and 11 were outside the range.  Thus, the bankruptcy court concluded that $306,110.23 of the payments were not made in the ordinary course.  The issue for the Seventh Circuit was whether the bankruptcy court set the range of ordinary course (within 16 to 28 days) too narrowly.  Jason’s Foods challenged the bankruptcy court’s decision in two ways.  First, it challenged the court’s use of an abbreviated historical period rather than the company’s entire payment history.  Second, it argued that the baseline comprises a too-narrow range of days surrounding the average invoice age during the historical period. Continue Reading

Supreme Court Enhances Creditor’s Right to Bar Debtor’s Discharge of Debts-Expanding Reach of Actual Fraud and Shareholder’s Liability

Until the recent U. S. Supreme Court’s decision in Husky International Electronics, Inc. v. Ritz, __ U.S. __, 136 S.Ct. 1581, 194 L.Ed.2d 655, 84 U.S. L.W. 4270 (2016),  there was disagreement in the circuit courts regarding whether a debtor in bankruptcy could be denied a discharge under 11 U.S.C. § 523(a)(2)(A) where the evidence of wrongdoing proved the debtor committed actual fraud, but there was no evidence that the debtor made a misrepresentation to the creditor seeking to bar the discharge.  For example, assume you represent a supplier who has a judgment against an insolvent company.  Assume further that you discover that the company’s major shareholder fraudulently transferred assets of the company to other entities which resulted in the company’s insolvency.  Accordingly, you file a piercing-the-corporate-veil claim against the shareholder and obtain a judgment.  However, before you can collect on the piercing claim, the shareholder files for bankruptcy protection.  You file an adversary proceeding seeking an order denying the discharge of the shareholder’s debt based on the fraudulent transfer scheme and the piercing-the-corporate-veil claim.  The shareholder counters and argues that the debt is nevertheless subject to discharge because § 523(a)(2)(A) requires evidence that the debt was obtained by actual fraud.  In the normal piercing case, a creditor will be hard pressed to present evidence that the debt was obtained by actual fraud, because the evidence usually is limited to showing that the ability of the company to pay its legitimate debt was hindered or delayed by the fraudulent acts of the shareholder.  Thus, the District Court of Texas and the Fifth Circuit Court ruled in favor of the shareholder and allowed the piercing debt to be discharged in bankruptcy.  This decision was in direct conflict with the Seventh Circuit’s decision in McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000) and the First Circuit’s decision in In Re Lawson, 791 F.3d 214 (1st Cir. 2015).  In McClellan and Lawson, the Courts followed the contrary rule holding that § 523(a)(2)(A) is not limited to misrepresentations and misleading omissions, but includes deliberate fraudulent-transfer schemes.  Such was the conflicting state of the law until the Supreme Court rendered its decision in Husky.

On May 16, 2016, the Supreme Court resolved the conflict and thereby enhanced the rights of creditors to prohibit a debtor in bankruptcy (including a shareholder liable based on piercing) from walking away from a debt arising from a fraudulent transfer scheme. The Court held that the term “actual fraud” in § 523(a)(2)(A) encompasses fraudulent conveyance schemes, even when those schemes do not involve a false representation.

Here are seven take-aways from the Husky case:

  1. There is a presumption that Congress did not intend “actual fraud” in § 523(a)(2)(A) to mean the same thing as a false representation;
  2. Actual fraud has long encompassed the kind of conduct involving a transfer scheme designed to hinder the collection of a debt;
  3. Anything that counts as fraud and is done with wrongful intent is “actual fraud” under § 523(a)(2)(A);
  4. Fraudulent conveyances, although fraudulent, do not require a misrepresentation from the debtor to the creditor;
  5. Fraudulent conveyances are not inducements based on fraud, but typically involve a transfer to a close relative, a secret transfer, a transfer of title without a transfer of possession, or a transfer based on grossly inadequate consideration;
  6. The fraudulent conduct is not in dishonestly inducing a creditor to extend the credit, but in the act of concealment and hindrance; and
  7. Nothing in the text of § 523(a)(2)(A) supports the position that the phrase “obtained by . . . actual fraud” requires not only that the relevant debts result from or be traceable to fraud, but also that the debts result from fraud at the inception of a credit transaction.

The Husky case will become an invaluable tool for creditors-rights attorneys who are able to establish sufficient evidence supporting a piercing-the-corporate- veil claim against a shareholder.  Even if the shareholder were to file for bankruptcy protection, a debt based on actual fraud, without a misrepresentation, will survive the bankruptcy discharge, because it is now understood that a false representation is not a necessary element of actual fraud and the Supreme Court in Husky refused to adopt such a requirement.

Federal Reserve Expresses Openness to Relaxation of HVCRE Regulations on Community Banks

Last year, as noted by this blog, the FDIC, OCC, and Federal Reserve imposed harsher capital requirements on certain “high volatility commercial real estate,” or HVCRE, exposures, in accordance with the Basel III international banking standards. These new requirements were opposed not only by the real estate industry but also by banking associations, particularly the Independent Community Bankers of America (ICBA). The ICBA argues that the Basel III rules were intended to apply only to large, internationally active banks, and that the rules place too great a regulatory burden on smaller institutions. A recent report by the Federal Reserve Bank of Philadelphia notes that CRE regulations disproportionately affect smaller banks, as “CRE represents approximately 50 percent of small bank loan portfolios, compared with just over 25 percent of large bank portfolios.” The report goes on to state that loans that might be classified as HVCRE under the new rules represent approximately 5% of total loans for the median commercial bank with total assets below $10 billion, “a modest, but certainly not insignificant, portion of small banks’ CRE portfolios.” Continue Reading

Ohio Revised Code §1301.401 – A Powerful Tool for Lenders with a Defective Mortgage

For years, it was generally accepted that mortgage creditors and bankruptcy trustees could assert the status of a bona fide purchaser and treat a defectively notarized mortgage as if that mortgage did not exist.  On February 16, 2016, our Supreme Court provided clarity regarding the legal effects of R.C. §1301.401 and provided protection to lenders regardless of whether their mortgages were defective.

In Re Messer, 2016-Ohio-510 was a referral to the Ohio Supreme Court from the Bankruptcy Court for the Southern District of Ohio.  Mr. and Mrs. Messer (the “Messers”) owned real property in Ohio.  In order to finance the purchase of the property, the Messers executed and delivered a mortgage to Mortgage Electronic Registration Systems (“MERS”) as nominee for M/I Financial Corp.  The mortgage was later assigned to JP Morgan Chase Bank, N.A. (“Chase”).  Although the mortgage was correctly signed by the Messers, the notary failed to certify the mortgage acknowledgment, although the notary did notarize other documents at the time of the closing.  The Franklin County Recorder accepted and recorded the mortgage on December 4, 2007.

On September 19, 2013, about six years after the defective mortgage was recorded, the Messers filed a Chapter 13 bankruptcy petition. The Messers scheduled the mortgage as the secured claim of Chase.

On December 20, 2013, the Messers filed an adversary proceeding against Chase seeking to extinguish the defective mortgage. Bankruptcy Judge Caldwell referred the state law questions to the Ohio Supreme Court for resolution.

The two questions for resolution were whether R.C. §1301.401 applies to all recorded mortgages in Ohio, and whether this statute provides constructive notice to the world of the existence and contents of a recorded mortgage that was deficiently executed under R.C. §5301.01. The Court answered each question in the affirmative.

The Court began its analysis by considering R.C. §5301.01(A) which sets forth the requirements for a mortgage in Ohio. The section states:

A *** mortgage *** shall be signed by the *** mortgagor ***. The signing shall be acknowledged by the *** mortgagor *** before a judge or clerk of a court of record in this state, or a county auditor, county engineer, notary public, or mayor, who shall certify the acknowledgement and subscribe the official’s name to the certificate of the acknowledgement.

Thereafter, the Court considered R.C. §1301.401 and concluded that it provides that the recording of certain documents provides constructive notice:

(B) The recording with any county recorder of any document described in division (A)(1) of this section *** shall be constructive notice to the whole world of the existence and contents of [the] document as a public record and of any transaction referred to in that public record, including, but not limited to, any transfer, conveyance, or assignment reflected in that record.

(C) Any person contesting the validity or effectiveness of any transaction referred to in a public record is considered to have discovered that public record and any transaction referred to in the record as of the time that the record was first *** tendered to a county recorder for recording.

(Emphasis added.)

The Messers made several arguments contending that R.C. §1301.401 was not applicable to rescue a defective mortgage which failed to comply with R.C. §5301.01(A). The Court rejected each argument.

First, the Messers argued that R.C. §1301.401’s placement in the portion of the Revised Code relating to Ohio’s Uniform Commercial Code (“UCC”) means that the statute applies only to transactions governed by the UCC and does not apply to mortgages. The Court disposed of this argument noting that R.C. §1301.401’s clear and broad language indicates that it applies to “any document described in Division (A)(1)” of the section.  Further, the Court held that R.C. §1301.401(A)(1) clearly states that any document described or referred to in R.C. §317.08 is included in R.C. §1301.401.  Thus, the Court held that based on the unambiguous statutory language of R.C. §1301.401, this statute applies to all recorded mortgages in Ohio.

Not ready to surrender, the Messers argued that application of R.C. §1301.401 to recorded mortgages was inconsistent with R.C. §5301.25(A) and cannot provide constructive notice to a bona fide purchaser if the mortgage was not properly executed.

Again, the Court rejected this argument. The Court held that R.C. §1301.401 does not contradict R.C. §5301.25(A), but simply provides that the act of recording a mortgage provides constructive notice to the whole world of the existence and contents of the mortgage documents.

Finally, the Messers argued that, in enacting R.C. §5301.01(B) (providing for constructive notice for mortgages executed prior to February 1, 2002 and not acknowledged in the presence of, or not attested by, two witnesses) and R.C. §5301.23(B) (providing constructive notice where the mortgage document omitted the current mailing address of the mortgagee) show that if the General Assembly wished to create a constructive notice for deficiency-executed mortgages, it would have done so in R.C. Chapter 5301.

This final argument was also rejected by the Court. The Court stated that the existence of R.C. §5301.01(B) and R.C. §5301.23(B) does not preclude the General Assembly from recognizing other instances in which the recording of a deficiently-executed mortgage can provide constructive notice.

CONCLUSION

The Messer case is important because prior to the enactment of R.C. §1301.401, a defective mortgage was deemed not to provide constructive notice. See Rhiel v. The Huntington National Bank (In Re Phalen), 445 B.R. 830 (Bankr. S.D. Ohio 2011).  R.C. §1301.401 dispenses with the notion that a filed instrument is “not filed” if defectively executed.  Therefore, because the bankruptcy Trustee’s avoidance powers under 11 U.S.C. §544 are only effective if there is a lack of constructive notice, R.C. §1301.401 bars the Trustee from successfully defeating the interest of a mortgage lender whose mortgage is defectively executed, but nevertheless recorded.  This is great news for most lenders.

NCUA Approves Rules Easing Restrictions on Credit Union Commercial Loans

Last year, as discussed by this blog, the NCUA proposed a new set of regulations designed to ease restrictions on business lending by credit unions. These regulations would remove all prescriptive limits on member business loans (“MBLs”) and replace them with the fundamental principle that commercial loans must be appropriately collateralized.

The NCUA recently approved a final version of these regulations substantially identical to the proposed version. Most notable among the relatively minor changes from the proposed version:

  • The proposed rules loosened the limit on the aggregate dollar amount of commercial loans to a single borrower from 15% of the credit union’s net worth or $100,000 to 25% of the credit union’s net worth, provided that the additional 10% of the credit union’s net worth was fully secured at all times with a perfected security interest by readily marketable collateral. The final rules relax the limit even further by excluding from the limit any insured or guaranteed portion of a commercial loan made through a program in which a governmental agency insures or guarantees repayment.
  • Unlike the proposed rules, the final rules permit existing state rules to supersede Part 723 of the new rules if the state rules cover the same provisions as Part 723 and are no less restrictive. Any state rules previously approved by NCUA are grandfathered.

The new rules are set to take effect on January 1, 2017, except one. The existing rules require the principal of an MBL to provide a personal guarantee, or the credit union to seek a waiver from this guarantee obligation from the NCUA. This requirement will be abrogated 60 days after the new rules are published in the federal register.

Proposed Limitations On The Use Of Cognovit Notes

The Ohio General Assembly is currently considering a bill that would greatly restrict creditors’ ability to ask debtors to sign cognovit notes. A cognovit note allows a creditor, upon a debtor’s default, to enter judgment against the debtor without the usual notice or hearing.

Current Ohio law, specifically Ohio Revised Code Section 2323.13, generally enforces cognovit notes, but Ohio courts will not enter judgment on a cognovit note unless the note contains specific disclaimer language clearly and conspicuously visible, warning the debtor that signing the cognovit note surrenders the debtor’s rights to notice and a court trial upon default.1  Additionally, cognovit notes are banned entirely in consumer transactions.2 Continue Reading

NCUA’s Proposed Rules Concerning Credit Union Commercial Loans

Credit unions’ ability to lend to businesses may receive a boost if proposed NCUA regulations are approved. Business loans are becoming an increasingly important part of credit unions’ operations. Total business loans at federally insured credit unions grew from $13.4 billion in 2004 to $51.7 billion in 2014, growing from 3% of all total credit union loans to 6.8% over the same period. As of 2014, 36% of credit unions offer business loans, the vast majority of which (76%) are held by credit unions with assets greater than $500 million.

However, certain business loans, termed “member business loans” (“MBLs”), are limited by statute and regulation. An MBL is defined as a loan through which the borrower uses the proceeds for commercial, corporate, agricultural, or other business purposes, excluding extensions of credit that:  Continue Reading

Ohio Financial Institutions Tax and National Banks

In September, at the request of an Ohio-based national bank, the Office of the Comptroller of the Currency issued an opinion challenging the application of the Ohio Financial Institutions Tax (FIT) to national banks with their principal office in Ohio.

The opinion held that the FIT contradicted a federal statute that provides a national bank should be treated as a state bank chartered by the state in which the national bank has its principal office when state taxes are assessed.

The challenger maintain that the FIT contradicted federal law because Ohio chartered banks have a tax credit against the FIT for regulatory assessments paid to the Ohio Division of Financial Institutions but the FIT does not provide corresponding credit for national banks. The OCC agreed.

The opinion concluded that:

“Ohio law provides that each bank organization organized under Title XI of the Ohio Revised Code may claim a non-refundable tax credit against the FIT for regulatory assessments paid to the Ohio Division of Financial Institutions. The law provides no similar credit for regulatory assessments paid by bank organizations not organized under Title XI of the Ohio Revised Code, and it provides no credit for assessments paid to other financial regulators.  Thus, the FIT provides a tax credit to Ohio-chartered state banks that is not available to national banks.  This arrangement does not treat a national bank with its principal office located in Ohio as if it were an Ohio-chartered state bank . . .”

A review of OCC letter and review of Ohio Revised Code (“R.C.”) Chapter 5726 dealing with the FIT suggests from a substantive standpoint, the Department of Taxation would likely argue that the sum of FIT paid by an Ohio-chartered bank (taking advantage of the deduction) plus the Ohio regulatory assessment on such bank is equal to the FIT on a similarly situated nationally-chartered bank, so the treatment of the two banks is the same. The counter-argument is likely that the Ohio regulatory assessment isn’t under the FIT and shouldn’t count when assessing the federal preemption of the FIT.

Procedurally, a nationally-chartered bank can file for a FIT refund under R.C. 5726.30 for taxes paid within the last four years. Ohio Taxation Form FIT REF would be used.  The form contains space for the reason.  The Tax Commissioner then must act under R.C. 5703.70 by allowing briefing and/or a hearing.  The Tax Commissioner could issue a refund as relief sought (unlikely) or issue a negative Final Determination.  The bank would then have 60 days under R.C. 5717.02 to file an appeal of a negative Final Determination with the Board of Tax Appeals.  Decisions of the Board of Tax Appeals may be taken to the Ohio Supreme Court.

Newly Effective HVCRE Loan Rules

Lenders who finance commercial real estate exposures should be aware of new regulations that impose harsher capital requirements on certain “high volatility commercial real estate,” or HVCRE, exposures. In June 2013, the FDIC, OCC, and Federal Reserve jointly approved proposed rules intended to implement new international banking standards, known as the Basel III Capital Accords, as well as establish new risk-based and leverage capital requirements for financial institutions, as required by Dodd-Frank. The rules have been in effect for all banks since January 1, 2015, having applied to the largest banks one year prior.

Under the rules, an HVCRE exposure is defined as “a credit facility that, prior to conversion to permanent financing, finances or has had financed the acquisition, development, or construction (“ADC”) of real property,” if it fails to satisfy any of the following three capital requirements: Continue Reading

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