A lert Mortgage Banking Commentary JUNE 27, 2001 Eleventh Circuit Throws Pepper at Wholesale Lenders by R. Bruce Allensworth (ballensworth@kl.com) Irene C. Freidel (ifreidel@kl.com) The payment by lenders of yield spread premiums in connection with broker-originated residential mortgage loans has been the subject of considerable class action litigation over the last five years. Since June 1997, lenders have achieved a long series of victories on the issue of class certification. By an order of magnitude, the courts have determined that class certification is inconsistent with the rigorous requirements of the federal rules of civil procedure, finding that common issues would not predominate. A recent decision of the United States Court of Appeals for the Eleventh Circuit, however, reopens the debate. On June 15, 2001, the United States Court of Appeals for the Eleventh Circuit (covering Alabama, Georgia and Florida) issued an opinion affirming the trial courts decision in Culpepper v. Inland Mortgage Corp. to certify a nationwide class of FHA borrowers to determine whether the payment of a yield spread premium by the defendant lender violates the antikickback provisions of Section 8 of the Real Estate Settlement and Procedures Act (RESPA). The opinion could be read to imply that yield spread premiums are per se illegal because they are calculated as a function of interest rate and loan amount. At least on the factual record before it, the court appears to give no credence to the argument that a yield spread premium has legitimate uses in a given transaction, such as providing the opportunity to finance some or all of the loan origination costs and fees that the borrower might otherwise pay from his or her own pocket or as allowing a borrower to temporarily buy down the loan interest rate. Instead, Culpepper avoids any examination of the economic realities of a particular loan and the brokers and borrowers intent in employing a yield spread premium, at least absent a threshold showing that the agreement between the lender and the broker contemplates a services-for-money exchange. The stance taken by the Eleventh Circuit in Culpepper appears to disregard the policy behind the statute, the economic reality of wholesale mortgage loan transactions, and the HUD Policy Statement that was thought to have laid this issue to rest two years ago. To understand the genesis of the June 15, 2001 opinion, we set forth a brief history of the Culpepper litigation. I. HISTORY OF THE CULPEPPER LITIGATION A. The Summary Judgment Proceedings In 1997, the trial court in Culpepper granted summary judgment to the defendant lender on the individual RESPA claims of the plaintiffs. The trial court held that the payment of a yield spread premium in connection with plaintiffs mortgage loan transaction was not prohibited by RESPA because it was a market-driven payment for goods which, under Section 8(c) of RESPA, is not a violation of the statute. Kirkpatrick & Lockhart LLP In the first appeal in the Culpepper action (Culpepper I), the Eleventh Circuit reversed the district court, addressing not only the grounds for decision by the trial court but also the alternative grounds asserted on appeal that the yield spread premium was a marketdriven payment for services. The Eleventh Circuit first held that the trial courts decision that the payment was for goods was flawed by concluding that, in a table-funded transaction, the lender and not the broker owns the loan from the outset. That is, the broker could not sell the loan to the lender because the lender already owned it. The Eleventh Circuit also rejected the lenders alternative payment for services argument on two grounds: first, that there was no evidence that the broker was not fully compensated by the one-percent origination fee it charged in connection with the transaction and, second, because the lender contradicted the theory that the payment was for services by stating in answer to interrogatories that the yield spread premium was paid to [the broker] [in part] for the slightly above-par yield on the mortgage note and [in part] for the right to service the loan. The Eleventh Circuit concluded by declaring that the Section 8(c) exception covering payments for goods, facilities or services was inapplicable because the payment of the yield spread premium was not a payment for goods or services. The court stated that the fact that the price of a referral is market-driven is not relevant if there is a referral in violation of the statute. Thus, the court presumed that the payment of a yield spread premium was a referral fee within the meaning of Section 8(a), and further that the yield spread premium was not subject to review under Section 8(c). In a footnote that was highly touted by the lending community, the Eleventh Circuit emphasized that its holding was highly dependent upon the facts of [the Culpeppers] financial transaction. We simply note that the particular facts here do not support the 2 conclusion that the yield spread premium in this case was paid as compensation for the services [the broker] provided to the Culpeppers. This observation was considered important because of its potential effect on class certification. The court vacated the trial courts denial of class certification and remanded for consideration of the certification decision in light of its opinion. The Eleventh Circuit issued a further opinion in its decision denying the lenders petition for rehearing. See Culpepper v. Inland Mortgage Corp., 144 F.3d 717 (11th Cir. 1998) (Culpepper II). The court expressly confirmed in Culpepper II that the lenders inability to obtain judgment as a matter of law on the current record does not prevent [the lender], on remand, from attempting to prove its case at trial as to the plaintiffs individual transaction. Id. (emphasis added). The court noted that, with respect to plaintiffs individual transaction, the lenders case was that the yield spread premium also represented additional payment for [the brokers] services to [the lender] and the [plaintiff borrowers]. Id. The Eleventh Circuit acknowledged the reasonableness test under RESPA and stated that it was not holding in Culpepper I that RESPA prohibits the payment of all reasonable yield spread premiums by mortgage lenders to mortgage brokers who actually furnish services or goods and thereby precludes buyers from financing closing costs through yield spread premiums. Id. The Culpepper opinions determined the law of the case, which imposed a significant negative constraint on the class certification decision issued by the district court, and on the Eleventh Circuits most recent decision affirming class certification. B. The Class Certification Proceedings On June 22, 1999, the federal district court in the Northern District of Alabama certified the proposed class in Culpepper v. Inland Kirkpatrick & Lockhart LLP Mortgage Corp., C.A. No. 96-BU-0917-S (N.D. Ala. June 22, 1999) (Culpepper III). The Culpepper III decision was plainly at odds with the March 1, 1999 HUD Policy Statement, 64 Fed. Reg. 10800 (1999), which was issued after the Eleventh Circuits first Culpepper opinion. It did not adhere to the guidance provided by the Eleventh Circuit in Culpepper II that appeared to counsel against class certification, and it ignored the reasoning of more than thirty cases where district courts by that time had refused to grant plaintiffs motions for class certification. In Culpepper III, the district court held that it was not required to investigate the reasonableness of the compensation provided by the broker because the yield spread premium paid was neither a payment for goods or services. Slip op. at 8. Citing to Culpepper I, 132 F.3d 692, 697 (11th Cir. 1998), the district court stated that yield spread premium payments are not for goods or services when their amount is not tied to the services provided. Id. The court further found that the defendant had failed to establish that the yield spread premium was for services where it had not produced any evidence that the yield spread premium is [connected] to anything but the difference between the par rate and the interest rate at which the mortgage was made. Slip op. at 9. According to the court, [t]he claims of the plaintiffs and any putative class hang largely, almost exclusively, on this issue. Id. The Culpepper III decision, however, did not address the March 1, 1999 HUD Policy Statement. On July 20, 1999, the trial court issued an additional order in Culpepper v. Inland Mortgage Corp., CV 96-BU-0917-S (N.D.Ala. July 20, 1999) (Culpepper IV), in which it stated that its class certification decision was consistent with the HUD Policy Statement because, according to the court, HUD requires a showing by the lenderin the so-called second sub-prong to the first prong of the 3 liability testthat the yield spread premium payment was actually compensation for the goods or services provided. In other words, according to the district court, the lender is required to demonstrate that the amount of the yield spread premium fee was inherent[ly] relat[ed] at the time of the transaction to the goods and services provided. Thus, the district court in Culpepper IV erroneously determined that a plaintiff could establish classwide liability against a mortgage lender under Section 8 of RESPA based on the method by which the mortgage lender calculated the amount of the yield spread premium paid in connection with a putative class members loan. II. THE ELEVENTH CIRCUIT JUNE 15, 2001 DECISION On June 15, 2001, the Eleventh Circuit affirmed the district courts class certification order holding that the lower court did not abuse its discretion (Culpepper V). In explaining its decision, the court states that the HUD Policy Statement is ambiguous as to the core of the class certification dispute. The court then embarked on an effort to determine the rule of liability applicable to yield spread premium claims. Clearly constrainedat a minimumby the law of the case set forth in its first Culpepper opinion on summary judgment, the Eleventh Circuit rejected the lenders argument that the HUD Policy Statement overruled Culpepper Is interpretation of Section 8(c) of RESPA. The lender argued that once it is established that goods, facilities or services were provided by the broker, a yield spread premium payment is permissible if it satisfies the reasonableness analysis of Section 8(c). The lender further argued, putting aside the reasonableness test, that even the Culpepper I opinion required the factfinder to consider whether the broker and borrower subjectively intended, in each loan transaction, for the yield spread premium to be a payment for the brokers services. The Eleventh Circuit, however, agreed with the plaintiffs analysis, which asserted that the HUD test Kirkpatrick & Lockhart LLP and the Culpepper I opinion were consistent, because according to the court and the plaintiffs, both require a showing that the yield spread premium was paid expressly in exchange for services. In adopting the plaintiffs rule of liability, the Eleventh Circuit first considered the meaning of the phrase in the Policy Statements liability analysis: whether goods or facilities were actually furnished or services were actually performed for the compensation paid (emphasis supplied). The court pointed to three reasons supporting the plaintiffs interpretation that the phrase requires that each yield spread premium be paid as part of a services-for-money exchange. First, the court stated that the phrase for compensation paid must be given meaning and the lenders interpretation of the liability test (which is consistent with HUDs) rendered the phrase meaningless. According to the court, the plaintiffs suggestion that for compensation paid means in exchange for compensation paid is semantically very plausible. Second, the court found that its interpretation of the HUD Policy Statement was consistent with Section 8(c), and the lenders interpretation was not. The court cited Section 8(c), which authorizes the payment of a fee by a lender for services actually performed. 12 U.S.C. § 8607(c). According to the court, the preposition for connotes an exchange and the term fee implies a money-forservices exchange. Thus, according to the court, only payments that a lender can prove are paid for services fall within Section 8(c)s safe harbor. Third, the court determined that Section 8(c) is an interpretive gloss on Section 8(a) rather than a list of exemptions bestowed on otherwise illegal conduct. According to the court, payments that are prohibited under Section 8(a) cannot be rehabilitated (or exempted) under Section 8(c). The court did not agree with what it perceived to be the lenders central argument: that payments coincident with referrals under Section 8(a) are legal under Section 8(c) if services were provided and the amount of the fee was reasonable. The crux of § 8(a)s liability test, even when the suspected referral fee is dressed up as something else, is whether the payment is to compensate a referrer for referrals; the 4 answer to that question lies in the terms of the agreement between the referrer and the recipient of the referral. The Eleventh Circuit further stated that its rule of decision did not run afoul of HUDs statement that yield spread premium fees are not illegal per se. The court posits that an indicia that the yield spread premium constitutes a payment for goods, services, and facilities provided would be, for example, if [the lender] required brokers to present a bill showing the services rendered, and how much the broker had collected in fees from the borrower, or [the lender] followed the advice of the Senate report to persons and companies that provide settlement services that they ensure that any payments they make are not out of line with the reasonable value of services received. Slip op. at 15. The very Senate report that the Eleventh Circuit relies on, however, suggests that the determination of whether a yield spread premium constitutes a payment for services turns on whether the brokers compensation is in line with the value of the services it provided, as opposed to being for specific individual services. This is consistent with the analysis that would be performed under Section 8(c) and Regulation X. The Eleventh Circuit, nonetheless, despite reference to the Senate report, finds that the reasonableness analysis of Section 8(c) is not applicable. Culpepper V rejects the lenders argument that plaintiffs position, if adopted, would put the lender in the position of not knowing whether its conduct was illegal at the time it pays a broker fee, because it would not know the intent of the broker and the borrower with respect to arrangements made for the brokers compensation. According to the court, [a]fter all, [the lender] may not know what services it has received when it pays the premium, but it does know that it has gotten a referral. In other words, the fact that a broker may rely on the premium for compensation does not mean that [the lender] is buying services. Slip op. at 17. In sum, the court states that it is adopting the sounder rule supported by Culpepper I that the terms and conditions under which a lender pays a Kirkpatrick & Lockhart LLP broker a yield spread premium can determine whether the yield spread premium is compensation for referring loans rather than a bona fide fee for services. There is no suggestion here that [the lender] negotiates yield spread premiums loan-byloan, rather than paying for them according to terms and conditions common to all the loans. Nor does [the lender] contend that it intends some yield spread premiums to pay for services and others to pay for referrals. Slip op. at 1718. The court concluded that the district court acted within its discretion in certifying a class [g]iven the test for liability that we interpret the HUD Statement and Culpepper I to impose. III. ANALYSIS A rule that would limit the RESPA inquiry merely to generalized evidence of the purpose underlying the payment of yield spread premium fees without consideration of the particulars of any transaction is inconsistent with the test for liability set forth in the HUD Policy Statement. HUD makes clear in its guidance that yield spread premium fees are subject to the reasonableness test as long as the broker provides a threshold quantity of compensable goods, services and/or facilities. Indeed, HUD expressly acknowledges that yield spread premium fees are calculated based on the interest rate and amount of a mortgage loanand the method by which they are calculated is not tied directly to the value of the goods, services, and facilities provided. HUD further characterizes lender-paid broker compensation that is not per se illegal as indirect fees, including those that are derived from the interest rate paid by the borrower , and payments based upon a percentage of the loan amount. 64 Fed. Reg. at 10086 (emphasis added).1 HUD states that to determine the legality of any individual yield spread premium payment, the factfinder need not consider whether the yield spread premium was tied to services provided by the broker. In the first prong of the test, HUD requires the factfinder to consider only what goods, services and/or facilities the broker provided (see services listed at 64 Fed. Reg. at 10085). The analysis is to be conducted with reference to HUDs letter to the Independent Bankers Association of America dated February 14, 1995, which lists specific services usually performed in the origination of a loan. Once the factfinder determines that the mortgage broker provided compensable goods, services, and/or facilities, he or she must then consider the reasonableness of the brokers total compensation for originating the mortgage loan. Thus: the first question is whether goods or facilities were actually furnished or services were actually performed for the compensation paid. The fact that goods or facilities have been actually furnished or that services have been actually performed by the mortgage broker does not by itself make the payment legal. The second question is whether the payments are reasonably related to the value of the goods or facilities that were actually furnished or services that were actually performed. 64 Fed. Reg. at 10084 (emphasis added). As one district court has interpreted the Policy Statement (64 Fed. Reg. 10080): the threshold question is simply whether the mortgage broker has provided legitimate goods or services in connection with the loan transaction. Once this showing is made, the question becomes whether the quantum of goods, facilities, and services provided is reasonably related to the total compensation received by the broker. As the Policy Statement unequivocally states: All payments, including payments based upon a percentage of the loan amount [i.e., yield spread premiums], are subject to the reasonableness test defined above. 64 Fed. Reg. at 10086 . As stated in the Policy Statement, HUD does not view the name of the payment as the appropriate issue under RESPA. 64 Fed. Reg. at 10084. 1 5 Kirkpatrick & Lockhart LLP Schmitz v. Aegis Mortgage Corp., C.A. No. 972142 (JMM/DSD) (D. Minn. April 23, 1999), slip op. at 1112. Nothing in a fair reading of the Policy Statement itself suggests that HUDs interpretation of RESPA requires, as an element of liability, a showing of the reasons for which a yield spread premium is paid. As the Senate report to which the Eleventh Circuit cites suggests, the best proof that the yield spread premium fee is a payment for services is the reasonableness of total broker compensation in any given transaction. Culpepper, however, ignores this point in its analysis. HUD expressly recognizes that yield spread premium fees are not inherently related to the value of the services providedand that they are calculated based on the loans interest rate and amount. Nonetheless, HUD states that there is nothing per se illegal about making payments calculated in such a fashion. If a yield spread premium fee were illegal because it was calculated based on the interest rate and loan amount and not tied to specific services provided, there would be no need to consider either the services provided by the broker as required by the first part of the test or the reasonableness of the brokers compensation under the second part of the test because yield spread premium fees would be per se illegal. If the Eleventh Circuit is saying that a broker payment runs afoul of Section 8 if the amount of that payment is derived or computed on the basis of something other than the specific value of the goods, services and facilities provided by the broker, that would seem inconsistent with, and not deferential to, HUDs determination that yield spread premium fees are not per se illegal. By definition, the amount of yield spread premium fees is calculated based on yield and not by specific reference to the goods, services and facilities provided in the specific transaction. The HUD Policy Statement expressly acknowledges that (1) yield spread premium fees are calculated as a function of the interest rate and loan amount; (2) there is nothing per se illegal about yield spread premium fees; and (3) yield spread premium fees can perform a valuable function in the lending process. The determinative test articulated by HUD 6 turns not on the manner of calculation of a yield spread premium, but instead on the relationship between total broker compensation, including yield spread premium, and the reasonable value of the goods, services and facilities provided by the broker. Regulation X itself provides guidance as to the construction of the preposition for in the first prong of the test announced in the Policy Statement. Regulation X states that [i]f the payment of a thing of value bears no reasonable relationship to the market value of goods or services provided, then the excess is not for services or goods actually performed or provided. 24 C.F.R. § 3500.14(g)(2) (emphasis added). The word for examined in this context suggests that proof that the amount of the total broker compensation, including yield spread premium, in a particular transaction was reasonably related to the market value of the goods, services or facilities provided would demonstrate that the payment actually was for goods, services or facilities actually performed or provided. This interpretation is bolstered by the Senate report discussion cited in Culpepper to the effect that settlement service providers should ensure that any payments they make . . . are not out of line with the reasonable value of the services received. See Culpepper, slip op. at 15, citing S. Rep. No. 93866 (1974), reprinted in 1974 U.S.C.C.A.N. 6546, 6551. It follows that if the total compensation received by the broker, including yield spread premium, from the lender is in line with the reasonable value of the services received, there is no violation of the statute regardless of any qualitative evaluation of the adequacy of the safeguards employed by the lender to ensure that its payments are indeed applied by the broker toward payment for specific goods, services and facilities actually provided. Stated otherwise, the fact that there is a reasonable equivalency between the amount of broker compensation, including yield spread premium, and the market value of the goods, services and facilities provided by the broker is the clearest evidence of the payment-for-services exchange, and that determination can only be made on a transaction-by-transaction basis. Putting aside the HUD Policy Statement and Regulation X, the district court and the Eleventh Kirkpatrick & Lockhart LLP Circuit in their class certification analysis in Culpepper rested their decisions to certify a class on their interpretation of the Eleventh Circuits opinions reversing the grant of summary judgment in Culpepper I and II. In Culpepper I, the Eleventh Circuit made clear that one of the reasons it did not consideron the record before itthat the yield spread premium was a payment for services was that there was no evidence that the loan origination fee paid by the Culpeppers to the mortgage broker was not intended by both [the broker] and the Culpeppers to compensate [the broker] fully for the work it did for the Culpeppers. 132 F.3d at 696. This fact-intensive point led the Eleventh Circuit to state that its holding, i.e., reversing the grant of summary judgment in favor of the defendant, was explicitly restricted to the facts as they appeared in the record, i.e., [the] holding here is highly dependent upon the facts of [the Culpeppers] financial transaction. 132 F.3d at 697 n.5 (emphasis added). Even if the intent of the individual parties to a mortgage loan transaction is an element of liability under Section 8 of RESPA, such intent can only be determined on an individualized basis notwithstanding broker agreements that do not express a purpose for which yield spread premiums are paid. The Eleventh Circuit brushed aside this component of its earlier holding in Culpepper I. Culpepper V likely is not the Eleventh Circuits final word on yield spread premium class actions. The current Culpepper decision addresses only one of the four cases argued contemporaneously to the Eleventh Circuit. The Culpepper V ruling plainly was informed and shaped by considerations of law of the case and the unique factual record, and its application to other cases with different procedural 7 histories and different factual records is uncertain. The broader thinking of the Eleventh Circuit panel will not be revealed until the court releases its opinions in three other related cases that are still pending before it. Further, the standard of review in Culpepper V was for abuse of discretion. The court was affirming the decision of the trial court to grant class certification. Outside of a handful of cases, the overwhelming majority of trial courts that have considered the issue of class certification have denied certification and, thus, the application by a circuit court for abuse of discretion standard in those cases may well lead to a different result than that reached in Culpepper V. Indeed, the Second Circuit currently has under advisement the trial court decision denying class certification in Potchin v. Prudential Home Mortgage Company, Inc. The courts ultimate decision there will provide further guidance to lenders on the treatment of yield spread premium fees in the courts. But absent an en banc rehearing by the Eleventh Circuit or intervening legislative or executive action, the recent Culpepper V decision reignites the dormant debate on yield spread premiums. * * * * * THIS NEWSLETTER IS FOR INFORMATIONAL PURPOSES ONLY. NOTHING HEREIN IS INTENDED OR SHOULD BE CONSTRUEDAS LEGALADVICE ORA LEGAL OPINION APPLICABLETO ANY PARTICULAR SET OF FACTS OR TO ANY INDIVIDUALS OR ENTITYS GENERAL OR SPECIFIC CIRCUMSTANCES. Please call or email us if you have any questions. Kirkpatrick & Lockhart LLP MORTGAGE BANKING/CONSUMER FINANCE GROUP Kirkpatrick & Lockhart LLP was founded in 1946, and, with more than 600 lawyers, is one of the thirty-five largest law firms in the United States. K&L attorneys are based in ten offices in key US cities Boston, Dallas, Harrisburg, Los Angeles, Miami, Newark, New York, Pittsburgh, San Francisco, and Washington. Our firm represents a broad range of clients in a wide variety of matters, including corporate and securities, e-commerce, investment management, insurance coverage, financial institutions, mortgage banking and consumer finance, creditors rights, intellectual property, tax, labor, environmental, antitrust, health care, and government contracts. More than half our attorneys are litigators. We litigate class actions on a range of financial issues, generally defending financial institutions, broker-dealers, public companies, and investment companies and their officers and directors against claims of violations of securities laws, consumer credit laws, and common law tort and contract claims. You can learn more about our firm by visiting our Internet website at www.kl.com. The Mortgage Banking/Consumer Finance Group provides legal advice and licensing services to the consumer lending industry. We counsel clients engaged in the full range of mortgage banking activities, including the origination, processing, underwriting, closing, funding, insuring, selling, and servicing of residential mortgage loans and consumer loans, from both a transactional and regulatory compliance perspective. Our focus includes both first- and subordinate-lien residential mortgage loans, as well as openend home equity, property improvement loans and other forms of consumer loans. We also have experience in multi-family and commercial mortgage loans. Our clients include mortgage companies, depository institutions, consumer finance companies, investment bankers, insurance companies, real estate agencies, homebuilders, and venture capital funds. Members of the Mortgage Banking/Consumer Finance Group and their telephone numbers and e-mail addresses are listed below: ATTORNEYS Laurence E. Platt Phillip L. Schulman Thomas J. Noto Costas A. Avrakotos Melanie L. Hibbs Irene C. Freidel Jonathan Jaffe R. Bruce Allensworth Daniel J. Tobin Anthony P. La Rocco Eric J. Edwardson Emily J. Booth Suzanne F. Garwood Steven M. Kaplan Kristie D. Kully Carol M. Tomaszczuk Nanci L. 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