Isaac Gradman authors article "Constitutional Rights: Using Loss-Shifting to Reduce Foreclosures"

By Isaac Gradman

Daily Journal
October 7, 2009

On May 21, 2009, President Barack Obama signed into law the Helping Families Save Their Homes Act, a bill aimed at easing the fallout from the greatest financial calamity since the Great Depression. But the manner in which Washington sought to keep troubled borrowers in their homes-by shielding large mortgage lenders from the costs of reworking the distressed mortgages they created and dumping these costs on investors-may well be unconstitutional.

Until the United States housing market crashed in the summer of 2008, mortgage lenders had been profiting handsomely from originating ever-increasing volumes of loans and selling them to Wall Street, which in turn packaged the loans and sold securities backed by their cash flows to investors. Because the appetite for such securities was insatiable, lenders were incentivized to disregard quality standards in an effort to increase volume, resulting in a glut of irresponsibly made loans. When housing prices leveled off, these loans began defaulting at unprecedented rates, sending the financial markets into a tailspin.

These distressed loans are no longer owned by the lenders who created them, but by the investors or bondholders who bought the derivative securities. However, the original lenders often remain involved as the "servicers" of the loans-receiving a fee to interface with borrowers and maximize mortgage payments on behalf of the bondholders. In its early attempts to curtail the fallout from this crisis, Washington passed legislation designed to reduce foreclosures by encouraging servicers to conduct loan modifications or "workouts" with borrowers to lower their payments and allow them to stay in their homes. Despite this encouragement, servicers, the only entities legally entitled to modify the loans, were reluctant to do because their contracts often required them to repurchase any loans they modified.

To combat this problem, Washington included a "Servicer Safe Harbor" in the Helping Families Save Their Homes Act that relieved servicers from their contractual obligations to bear the costs of workouts. Though a reduction in foreclosures is essential to stabilizing the housing and financial markets, Congress' method of achieving this goal simply shifts the costs of modifications from the lenders, who made the loans and attested to their quality, to the bondholders, who purchased an interest in the loans in reliance on these assurances. Such loss-shifting from one private party to another, in the name of the public good and without compensating the aggrieved party, is precisely the type of governmental conduct that is prohibited by the Takings Clause of the Fifth Amendment.

The Takings Clause provides: "[n]or shall private property be taken for public use, without just compensation." The Supreme Court has held that the purpose of the Takings Clause is "to prevent the government from forcing some people alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole." Eastern Enterprises v. Apfel, 524 U.S. 498, 522 (1998). Though Supreme Court precedent on how this to a given government action is highly fact-dependent and varied, a close look at the case law reveals a substantial possibility that the Supreme Court would find the Servicer Safe Harbor constitutionally infirm.

In Connolly v. Pension Benefit Guaranty Corp., 475 U.S. 211, 224 (1986), the Supreme Court revealed that, in the "regulatory takings" context (when a law or regulation indirectly causes an alleged taking, rather than a "classic taking" involving direct government appropriation of private property), the Takings Clause analysis is intentionally malleable, allowing for the evaluation of each case's particular circumstances. However, to aid in this determination, the Supreme Court identified three factors of "particular significance": the economic impact of the regulation on the claimant; the extent to which the regulation has interfered with distinct investment-backed expectations; and the character of the governmental action.

So how might the Supreme Court evaluate a Takings Clause challenge to the Servicer Safe Harbor? To answer this question, it is helpful to review the opinion in Eastern Enterprises, which provides the best recent example of a challenge to regulatory loss-shifting. In that case, Eastern Enterprises, a former coal operator, objected to the Coal Act's requirement that it contribute premiums to stabilize a health care fund for retired coal workers based on its participation in the coal industry some 30 years prior.

In the majority opinion, written by Justice Sandra Day O'Connor, the Supreme Court first noted that while "a strong public desire to improve the public condition is not enough to warrant achieving the desire by a shorter cut than the constitutional way of paying for the change," the mere fact that legislation would destroy or ignore existing contractual rights does not necessarily make it an illegal taking.

Analyzing the regulation under the three factors articulated above, the Supreme Court determined that the first factor - economic impact - was satisfied because the Coal Act imposed a burden on Eastern Enterprises of $50 to $100 million. Under the second factor-interference with reasonable investment-backed expectations-the Supreme Court concluded that the Coal Act's allocation scheme reached back 30 to 50 years to "attach[ ] new legal consequences to an employment relationship completed before its enactment," and thus interfered with Eastern Enterprises' expectations. Finally, as to the nature of the governmental action, the Supreme Court found that, while it was understandable that Congress would seek a legislative remedy to what it perceived to be a significant problem, that solution had singled out certain employers to bear a substantial burden that was not related to any commitment they had made or injury they had caused.

Based on these findings, the Supreme Court held that the Coal Act's operation violated the Takings Clause and should be enjoined as applied to Eastern Enterprises.

The makeup of the Supreme Court has changed since Eastern Enterprises was decided in 1998 and will likely experience further change before any constitutional challenge to the Servicer Safe Harbor can be heard. This, combined with the fact that the Supreme Court has gone the other direction on similar regulatory takings challenges, makes the outcome of any such challenge difficult to predict. However, the Eastern Enterprises analysis of the three substantive factors to invalidate the Coal Act would seem to apply with even greater force to the Servicer Safe Harbor.

First, the economic impact of the legislation is tremendous. In a pending New York State Supreme Court case entitled Greenwich Financial Services v. Countrywide Financial Services, bondholders allege that Countrywide (formerly one of the nation's largest lenders and now, as part of Bank of America, one of its largest servicers) is liable for the large majority of $8.4 billion in losses from loan modifications that it agreed to perform to settle charges by state regulators of irresponsible lending practices. The Servicer Safe Harbor has now provided Countrywide with an argument that it is no longer required to bear the costs of these modifications. If the court agrees , billions of dollars in losses will be shifted to investors. And this is only a fraction of the significant economic impact engendered by this legislation.

Second, the Safe Harbor obliterates the reasonable investment-backed expectations of investors. Many investors specifically included provisions in their investment contracts that prevented servicers from modifying the terms of the underlying mortgages without paying for them. Allowing the government to abrogate these contractual rights without just compensation would work a significant injustice against the investors who believed their contracts protected them from this very risk (not to mention discouraging future investment in U.S. financial instruments in general).

Third, just as in Eastern Enterprises, the nature of this government action singles out an isolated group to bear a substantial burden that is largely unrelated to any commitment it made or injury it caused. Indeed, it would be difficult to argue that the bondholders who invested in these loans under the impression that they were properly originated were somehow more responsible for the existence of defective loans than the lenders who created them.

The Supreme Court in Eastern Enterprises made clear that "justice and fairness require that economic injuries caused by public action must be compensated by the government, rather than remain disproportionately concentrated on a few persons." Similarly, justice and fairness dictate that Washington, rather than foisting the cleanup costs of this great financial calamity on an insular minority, be required to compensate investors for any losses that result from the enactment of the Servicer Safe Harbor.

Isaac Gradman is a litigation attorney at Howard Rice who specializes in litigation arising from the subprime mortgage crisis. In 2008, Mr. Gradman launched The Subprime Shakeout, a blog that explores developments in the subprime mortgage crisis from a legal perspective. He can be reached at IGradman@howardrice.com.

Reprinted and/or posted with the permission of Daily Journal Corp. (2009).