by John C. Murray
© 2004. All rights reserved.
In a case decided on July 13, 2004, by the U.S. Court of Appeals for the District of Columbia Circuit, Nat'l Home Equity Mortg. Ass'n v. Office of Thrift Supervision, 2004 U.S. App. LEXIS 14306, the court affirmed the ruling of the district court, 271 F. Supp.2d 264 (D. D.C. 2003), which held that the Office of Thrift Supervision ("OTS") did not exceed its authority in promulgating a rule making its prepayment-penalty and late-fee regulations inapplicable to state-chartered housing creditors.
The plaintiff (a national trade association including state-chartered housing creditors) challenged the OTS determination, effective July 1, 2003, which revised the regulations under the Alternative Mortgage Transactions Parity Act ("Parity Act," governing mortgage loans for which the term or interest rate or both are adjustable rather than fixed) relating to prepayment penalties and late fees so that they were no longer applicable to state housing creditors. The court of appeals noted that even though the OTS had issued a rule in 1996 adding late charges and prepayment penalties to the regulations that were applicable to state-chartered housing creditors, it later determined that the imposition of such fees "might be contributing to predatory lending practices in the subprime mortgage market." Id. at *5. (The OTS's issuance of its rule in 1996 was particularly significant because it preempted local law with respect to all other housing lenders except credit unions and commercial banks, which are not regulated by the OTS under the terms of the Parity Act.) As a result of this determination, the issued its final rule in 2002 making its prepayment-penalty and late-fee regulations inapplicable to state-chartered housing creditors, because they were not "essential or intrinsic" to a creditor's ability to engage in alternative mortgage transactions (thereby requiring state-chartered housing creditors to again comply with state laws governing these charges). The plaintiff challenged the final rule in the district court action, alleging that the OTS lacked authority to designate which of its regulations applied to state-chartered housing creditors and that the final OTS rule was "arbitrary and capricious."
The district court ruled that the OTS had the authority and ability to take such action, and that adoption of the amended rule was not arbitrary and capricious. The court stated that, "Congress intended to preempt regulations authorizing AMTs [Alternative Mortgage Transactions], not all regulations governing AMTs." (emphasis added). 271 F.Supp.2d at 270. The court stated further that, "the parity [Congress] sought to achieve between state and federal lenders is the ability to engage in AMTs, not competitive equality." Id. at 273. Because the district court found that the interpretation of the Alternative Mortgage Transaction Parity Act (Parity Act) by the OTS was permissible, it determined that it would defer to the OTS' interpretation and its ability to issue regulations thereunder and would further defer to the OTS' conclusion that prepayment fees and late charges were not "essential or intrinsic" to the ability of state housing creditors to provide alternative mortgage transactions. The district court stated that, "[e]ven greater deference must be accorded here because OTS has made a predictive judgment within the field of its expertise (citation omitted)." Id. at 276. The district court also rejected the plaintiff's argument that the OTS' change in policy was not entitled to deference because its interpretation had been inconsistent, stating that, "a change in OTS' interpretation of the Parity Act does not undermine . . . the deference this Court must afford OTS' Amended Rule." Id. at 275. The district court noted that although the OTS' interpretation of the Parity Act changed in 1996 (see discussion above), its current position was consistent with its interpretation of the Parity Act from 1982 through 1996, at which time it first diverged from its original position and concluded that its regulations regarding prepayment penalties and late charges were applicable to state housing creditors.
The only issue raised by the plaintiff with the D.C. Court of Appeals was whether the OTS rule was based on an impermissible interpretation of the Parity Act. The court of appeals determined that the Parity Act was did not express an intent to preempt all laws applicable to AMTs, and noted that the applicable statutory language specifically directed the OTS to identify and publish those particular regulations that were inappropriate (and thus inapplicable to) state housing creditors. The Court of Appeals next ruled that OTS's interpretation of the rule was permissible, because Congress had specifically granted the OTS the authority to "identify those portions" of its regulations that were "inappropriate for" application to nonfederally chartered creditors. According to the Court of Appeals, "the purpose of the Act is served - and the agency's responsibility thereunder is discharged - if the OTS makes applicable to state creditors only those regulations 'essential or intrinsic to their ability' to engage in AMTs." 2004 U.S. App. LEXIS 14306, at *12. Finally, the Court of Appeals rejected the plaintiff's argument that the OTS final rule was not entitled to deference because it departed from previous agency policy. The court found that the OTS had provided a "reasoned analysis" for its change in course, because of its legitimate concern -- backed up by solid evidence, including documents submitted by 46 state Attorneys General -- that state housing creditors were engaging in predatory subprime lending, and because "the agency's change in course is simply a return to the view it held consistently form its first implementation of the Parity Act in 1983 until 1996." Id. at *13.
Discussion:
1. Federal associations may include prepayment penalty clauses in commercial loan documents and enforce such clauses according to their terms regardless of any state law to the contrary (including equitable principles) because C.F.R. §§ 545.2 and 545.34(c), as amended at 49 F.R. 43044, authorize a Federal association to include a prepayment penalty clause in any loan it makes and to enforce such a clause in accordance with its terms regardless of any state law - including equitable principles in a foreclosure action - which purports to prohibit the collection of a prepayment penalty under certain circumstances. Because federally chartered depository institutions had already been authorized to engage in such alternative mortgage financing, Congress enacted the Parity Act to eliminate the discriminatory impact that those regulations have upon non-federally chartered housing creditors and provide them with parity with federally chartered institutions by authorizing all housing creditors to make, purchase and enforce alternative mortgage transactions so long as the transactions are in conformity with the regulations issued by the Federal agencies. 12 U.S.C. § 3801(b). The Parity Act expressly preempts state laws that prohibit alternative mortgage transactions, and provides that state-chartered lenders may make variable-interest home mortgage loans and other alternative mortgage transactions on the same terms as federally chartered lenders, "notwithstanding any State constitution, law, or regulation." 12 U.S.C. §§ 3803(c) and 3804. At the time of enactment, states were allowed to opt out of the preemption, but my understanding is that only six have done so: Arizona (in part); Maine; Massachusetts; New York; South Carolina; and Wisconsin (in part). By virtue of the OTS's revised rule, alternative mortgage transactions originated by state-chartered housing creditors are now subject to state limits on prepayment fees and late-payment charges, which are no longer preempted by the Parity Act. But the OTS declined to make its new rule retroactive, fearing that "such a position would seriously disrupt the mortgage markets." 67 Fed. Reg. 60550 (2002).
2. Prepayment fees have become an integral part of loan pricing for many subprime loan investors. As a result of the recent policy change by the OTS with respect to prepayment and penalties and late charges under the Amended Rule, lower-credit-quality borrowers now may find that they will pay a higher interest rate, but incur a shorter turnover time before refinancing their loans. Some borrowers may be unable to find credit at a reasonable price because credit for these borrowers is priced after taking into account state law restrictions on prepayment penalties. Average loan income is likely to drop as yield-spread premiums for subprime loans are reduced due to the increased likelihood of refinance transactions. As a result, some lenders may reintroduce alternative-loan-program features, such as limited-term shared-appreciation clauses, to substitute for prepayment fees. Now that state-chartered lenders are no longer exempt from state lending laws, the likely effect is that non-federal mortgage lenders will be less likely to make loans to subprime borrowers or low-income consumers with unfavorable credit ratings. (But the imposition by lenders of prepayment penalties and late fees may be subject to abuse, particularly with respect to subprime consumer loans. See Nat'l Home Equity Mortg. Ass'n v. Office of Thrift Supervision, supra, 271 F.Supp.2d at 277, where the district court referred to a letter from 46 state Attorneys General stating their "concern that the OTS 1996 Rule 'had encouraged abusive practices, particularly on the part of nonfederally regulated mortgage lenders'". The major credit-rating agencies believe that this lending-law change could reduce the number of new loans originated with prepayment fees and lower the term and amount of prepayment penalty fees for any loans that do contain such provisions. The final OTS rule also is expected to have a negative effect on issuers of some mortgage bonds, i.e., those that package mortgage prepayment charges into bonds known as "net interest margin securitizations ("NIMS"). The rating agencies predict that if the term and amount of prepayment fees are reduced, projected cash flows available to the transactions will be decreased, and that this will negatively impact NIMS sizes and credit enhancement requirements.
3. In a decision recently issued by the New Jersey Supreme Court, Glukowsky v. Equity One, Inc., 848 A.2d 747, 2004 N.J. LEXIS 553 (2004), the court reversed the holding of the appellate court, which had ruled that the plaintiff's state-law claims regarding the prepayment fees charged by the lender were not preempted by 12 C.F.R. § 560.220 because the regulation was adopted arbitrarily and exceeded the scope of authority Congress delegated to the OTS under the Parity Act. The plaintiff had obtained a $72,000 residential mortgage from the defendant in 1999, before the OTS issued its final rule in 2002 making state-chartered housing creditors again subject to state-law restrictions on late fees and prepayment penalties. The New Jersey Supreme Court stated that, "We accept OTS's explanation that its 1996 rulemaking represented one permissible interpretation of the Parity Act." Id. at *31-32. The court reasoned that because the OTS is the agency responsible for enforcing that Parity Act, its interpretation of the Act is entitled to "substantial deference." Id. The court cited several other federal court decisions for the proposition that the OTS acted, in issuing its rule in 1996, within the scope of the authority delegated to it by Congress by incorporating § 560.34 into § 560.220 to allow state-chartered lenders to impose prepayment penalties in alternative mortgage transactions. This action, the court determined, was a "sensible interpretation of the language of the Act in 1996, and the fact that the OTS later altered its position with respect to prepayment penalties did not require a conclusion that its position until that time was an impermissible construction of the statute or that the final rule would apply retroactively. The court stated that, "We cannot conclude, based on the language of the Parity Act of its legislative history, that Congress would not have sanctioned OTS's interpretation of the Act." Id. at *46.
4. See also McCarthy v. Option One Mortgage Corp., 362 F.3d 1008 (7th Cir. 2004). In this case the court held that the OTS, pursuant to 12 C.F.R. § 560.220, regulates prepayment penalties and authorizes state housing creditors, like their federal counterparts, to charge prepayment penalties to consumers. This case involved an action brought before the OTS revised its rule regarding prepayment penalties. The court stated, at 1011:
"Although federally chartered lenders were previously permitted to issue alternative mortgages, many states had laws prohibiting state-chartered lenders from providing this type of credit. The Parity Act's purpose is to 'eliminate the discriminatory impact that those [state] regulations have upon nonfederally chartered housing creditors and provide them with parity with federally chartered institutions.' 12 U.S.C. § 3801(b). Indeed, the Parity Act provides equal opportunity for state-chartered lenders to offer alternative mortgages as long as they comply with federal regulations. If compliance is achieved, state regulations are preempted by the Parity Act to the extent that they block state lenders from extending credit on terms permitted under federal regulations. See Ill. Ass'n of Mortgage Brokers v. Office of Banks and Real Estate, 308 F.3d 762, 768 (7th Cir. 2002); Nat'l Home Equity Mortgage Ass'n v. Face, 239 F.3d 633, 636 (4th Cir. 2001); Shinn v. Encore Mortgage Servs., Inc., 96 F. Supp. 2d 419, 423 (D. N.J. 2000). To trigger preemption, lenders must comply with regulations governing federal savings and loan associations, promulgated by the Office of Thrift Supervision ('OTS'). 12 U.S.C. § 3803(a)(3).The compliance standard is satisfied if a transaction is in 'substantial compliance' with the relevant regulations. 12 U.S.C. § 3803(b)(1). OTS regulates prepayment penalties and authorizes state housing creditors, like their federal counterparts, to charge prepayment penalties to consumers. 12 C.F.R. § 560.220; Shinn, 96 F. Supp. 2d at 423. In contrast, the Illinois Interest Act prohibits prepayment penalties for loans with an annual percentage rate that exceeds 8%. 815 ILCS 205/4(a). As this provision is in direct conflict with the Parity Act, the Illinois Interest Act's prohibition of prepayment penalties is preempted if a non-federal housing creditor elects to be governed by and complies with federal law. As preemption is an affirmative defense, it is the defendants' burden to establish that [the lender] substantially complied with the OTS regulations. In this case, summary judgment is appropriate because the defendants have met their burden by demonstrating that [the lender] is a housing creditor and that it substantially complied with the regulations identified as applicable by OTS in 12 C.F.R. § 560.220: 12 C.F.R. § § 560.33 [late charges], 560.34 [prepayments], 560.35 [adjustments to home loans], and 560.210 [disclosures for variable rate transaction]."
. . . . . . . . . . . . . . .
However, the court noted the following, at 1011 n. 2:
OTS changed the regulations applicable to non-federal housing creditors effective July 1, 2003; 12 C.F.R. § 560.220 now identifies only § § 560.35 and 560.210 as applicable for state housing creditors.
5. See generally, John C. Murray, Federal Preemption of State Prepayment-Penalty Statues: The OTS Reverses Itself, 18 Prob. & Prop. 63 (May/June 2004).
