JULY 2004
by Laurence E. Platt
Holding innocent loan purchasers responsible for the predatory lending violations of lenders is the rage among legislators these days. Makes sense, doesn’t it? Cash strapped governments cannot afford to fund enforcement of their own laws. The ‘soundbite’ that loan purchasers provide the ‘oxygen’ without which abusive lenders could not operate is compelling. Simply draft the capital markets to police the primary mortgage markets by holding them accountable for the misdeeds of others and the problem will go away. Imagine the surprise, then, of the legislators in Georgia, New Mexico and, just last week, New Jersey when they realized they had to soften their newly enacted anti-predatory lending laws to enable their constituents to obtain mortgage loans.
In the spirit of Robin Hood, proponents of the assignee liability provisions in anti-predatory lending laws would like to tap the financial resources of loan investors—who often have deeper pockets than originating creditors— to compensate victims of predatory practices. But by forcing loan investors to pay for wrongs perpetrated by loan originators, consumer groups and other advocates of predatory lending laws are harming the consumers they most want to help. Rather than confront harsh economic penalties and a confusing array of new state and local laws, loan purchasers are opting out of the high-cost loan market in states that seek to hold them responsible for the lender’s violations. In turn, fewer home loan options are available in these states to underserved borrowers.
While loan purchasers complain about the inherent unfairness of the new predatory lending laws, consumer groups correctly assert that assignee liability for consumer credit violations is nothing new. The birth mother of assignee liability for predatory lending violations is the Federal Trade Commission’s 1975 Holder Rule for the
Preservation of Consumer’s Claims and Defenses. The Holder Rule makes it illegal to take or receive a contract for the sale of consumer goods or services that does not include a provision making the holder of the contract subject to all claims and defenses that the debtor could assert against the seller, subject to a cap on recovery. It provides neither a private right of action nor a measure of damages. The Holder Rule simply permits a consumer to assert against an assignee any claims and defenses that the consumer could have asserted against the originating creditor, such as a breach of warranty claim related to the sale of defective goods. Although the Holder Rule does not apply to most residential mortgage transactions, its 25-year old philosophy lies at the heart of the debate over assignee liability and predatory lending.
Underlying the Holder Rule are two simple premises. First, the consumer’s obligation to repay a debt to a seller of goods or services should not be divorced from the seller’s obligation to perform, even if the seller transfers the debt to an innocent third party. Second, the commercial purchaser of the debt is in a better position than the consumer to police the marketplace and ensure that a seller lives by its word.
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The Holder Rule was as controversial over a quarter century ago as HOEPA and state anti-predatory lending laws are today. The explicit purpose of the Holder Rule, according to the FTC, was to repudiate the age-old Holder in Due
Course Doctrine, codified in Article 3 of the Uniform Commercial Code and still the law in all 50 states. The Holder in Due Course Doctrine permits an innocent purchaser to acquire third party debt free from virtually any claims and defenses that an obligor could assert against the original creditor. The obligor can assert such claims against the original creditor, but cannot use those claims as a defense against paying the debt to its holder.
The Holder in Due Course Doctrine is based on a notion of fundamental fairness: one that does no wrong should not be responsible for the misdeeds of another, absent a showing of prior knowledge or complicity. The fact that an innocent purchaser may have the economic wherewithal to compensate a wronged obligor does not matter—there is simply no room for “Robin Hood” in the modern commercial marketplace.
The FTC, however, felt differently, opting instead to reallocate the costs of seller misconduct to assignees. Relying on testimony from several consumer groups, the FTC stressed, in adopting the Holder Rule, that commercial purchasers are in a better position to return such costs to the sellers through lawsuits and contracts.
Delighted as they were with their victory, consumer groups wanted more. They fought for years for the extension of the 1975 Holder Rule to residential mortgage loans, and they succeeded in part in 1994 when Congress enacted
HOEPA to cover refinancings of residential mortgage loans. Consumer groups are still not satisfied, claiming that the
“high cost” triggers under HOEPA exclude too many loans in need of relief from the Holder in Due Course Doctrine.
The crusade for state and local anti-predatory lending laws with substantially lower triggers is the latest effort to eradicate the Holder in Due Course Doctrine. The most important element in this battle, according to consumer groups, is to replicate the Holder Rule’s repudiation of the Holder in Due Course Doctrine by making innocent assignees responsible for an originating lender’s misdeeds. This time, however, innocent purchasers of loans are less willing to put their money at risk when they have engaged in no wrongdoing.
The consumer groups, however, don’t seem to understand this reluctance. Faced with mounting criticism that antipredatory lending laws undercut the availability of consumer credit to underserved borrowers, consumer groups assert that private industry made the same claims of unfairness and doom and gloom over 25 years ago when the FTC enacted the Holder Rule, and yet, they argue, the “parade of horribles” never materialized in the ever thriving nonmortgage consumer credit market. Why, they ask, are the capital markets not accepting their “responsibility” this time? The answer is simple.
State anti-predatory lending laws differ from the parent that bore them in three material ways. First, the new wave of anti-predatory lending laws gives consumers an economic “free ride.” The FTC Holder Rule decidedly does not.
Second, state anti-predatory lending laws force assignees to pay significantly higher penalties for wrongs they didn’t commit than those possible under the Holder Rule. Third, subjective standards are at the heart of state anti-predatory lending laws such that lenders acting in good faith cannot reasonably determine in advance whether they are violating the law. The typical claim under the FTC Holder Rule, on the other hand, is a breach of warranty that a good or service does not perform as represented, a fact that presumably is in the control of the seller.
In designing the Holder Rule, the FTC did not intend to give consumers an economic windfall at the expense of innocent purchasers who happen to have deep pockets. The Holder Rule merely allows debtors to receive compensation for tangible losses, typically from debt-serviced goods or services that turn out to be defective. By contrast, under the

new predatory lending paradigm, consumers can obtain a loan and spend all the money. They can later bring suit under a predatory lending law, alleging excessive point and fees, for example—and, if successful, recoup the equivalent of not only the points and fees, but the entire loan principal.
With the sale of goods and services, one can fathom a legitimate, good faith consumer claim that the financial purchase price exceeds the reasonable value of the defective good or service. A consumer pays a contractor $7,500 to install siding, and the contractor walks away with the money without performing the work. A consumer buys a washing machine for $500, and it never works. In each case, the indebtedness is incurred to purchase a good or service that turns out to be defective. The loss is demonstrable and tangible.
With lending money, however, one cannot reasonably argue that the credit extended to a consumer is worth less than the original principal amount of the debt. There is thus no rational reason for a borrower to reap an economic windfall in the form of an extinguishment of the borrower’s obligation to repay the principal of the loan. Yet this is exactly what can happen under state predatory lending laws. Claims under the new anti-predatory lending paradigm are, in effect, claims that the debt itself is “defective.” Yet these claims are brought because of problematic loan terms or excessive interest rates or points and fees—not because there is anything wrong with the money the borrower received. If a consumer receives a $100,000 loan, the original principal balance is still worth $100,000. The upfront cost to acquire the debt, or the interest rate on the debt, may be excessive. But the value of the original principal amount of the debt does not change.
Let’s take an example. A borrower incurs a debt of $100,000, the proceeds of which are used to pay off a belowmarket rate affordable housing loan of $75,000, a tax lien on the property of $5,000, a credit card debt of $12,000, and closing costs of $8,000. Assume the loan violates a state’s anti-predatory lending law. Should the borrower be excused of liability for the entire loan? Of course not. The borrower received a demonstrable benefit of discharging existing indebtedness in various forms. Maybe the borrower should not have to pay the higher interest on a subprime loan that refinanced another subprime loan. Maybe the borrower should receive a refund of some or all of the closing costs. But what fairness is there in a remedy that gives the borrower a free pass on repaying the principal balance of the loan, when the borrower clearly benefited? Again, the cost of acquiring or repaying the indebtedness may be
“defective,” but the original principal balance of the loan is not. In this way, extending the FTC Holder Rule to residential mortgage lending is neither reasonable nor fair.
Unlike state anti-predatory lending laws, the FTC Holder Rule does not create any causes of action or provide any damages. Consumers can assert against assignees only what they could assert against sellers, with all the underlying state law limitations. State anti-predatory lending laws, on the other hand, create a cause of action for a consumer to seek draconian damages. Why does that difference matter? These laws have built-in punitive damages or penalties, disguised as statutory damages, entitling a consumer to two or three times the amount of interest and financial charges already paid and, in some cases, to be paid by the consumer. They compel a judge to award the enumerated damages irrespective of actual loss or actual harm by or to the consumer and without regard to a lender’s intent to violate the law or its good faith efforts to comply with a state’s subjective prohibitions. This pyramiding of penalties under the pretext of statutory damages can eat up a loan’s principal with a Pac-man-like efficiency. The result is the effective extinguishment of the debt, but not an extinguishment of the real economic benefits received by the borrower. The innocent holder is left footing the bill.
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Consumer advocates would have you believe that the cap on damages in some of these state’s anti-predatory lending laws protects assignees against egregious results. What they don’t say, however, is that the absurd measure of statutory damages where harm to the consumer is irrelevant assures that virtually any violation will result in massive payouts by the assignee, as well as the evaporation of the debt. And, unlike most consumer credit transactions subject to the
Holder Rule, the loan size of transactions subject to state anti-predatory lending laws often exceeds six figures. Little wonder that the capital markets are increasingly sewing their pockets shut to higher-cost loans, rather than letting them be picked by those who claim that innocent assignees should bear the cost of another’s misdeeds simply because they can afford to do so.
Determining whether a loan benefits a borrower is one of the standard requirements of state anti-predatory lending law that most frustrates lenders. This test is inherently subjective and laden with value choices with which reasonable people may disagree in good faith. Some consumer advocates claim, for example, that no debt consolidation loan can benefit a borrower, even if the interest rate to the borrower is materially reduced. Consolidating credit card debt into a cheaper home equity loan exposes the borrower to a risk of foreclosure that is not present if the borrower defaults on a credit card, some argue. Is the borrower better off or worse off in this situation? Reasonable people plainly disagree on this issue. Unlike a friendly disagreement, however, the consequence of an incorrect judgment made in good faith can be the complete extinguishment of the loan. The bottom line is that a lender and loan purchaser cannot know in advance whether a government regulator or class action plaintiff will argue after the fact that the good faith judgment of the originating lender was wrong.
Contrast this with the original purpose of the FTC Holder Rule. Fundamental to the Holder Rule is the principle that a consumer’s obligation to pay a debt and a seller’s obligation to stand behind the goods or services financed with such debt should not be separated, even if the seller transfers the debt to a third party. If a seller breaches a warranty or engages in misrepresentation or fraud in connection with the transaction giving rise to the debt, the consumer’s obligation to pay the holder may be reduced or eliminated. This goal of not separating the seller’s and borrower’s respective obligations to perform is the intellectual foundation for assignee liability. Yet in a routine Holder Rule claim, a seller controls the circumstances that give rise to a claim; it knows or reasonably should know if the goods or services are what they are represented to be. In the case of anti-predatory lending laws, however, the subjective standards to determine what is in the borrower’s welfare are outside the control of the lender and any subsequent loan purchaser. A lender cannot warrant that a borrower is better off with or without a loan on particular terms; while it can render an opinion on this matter, it is foolhardy for a lender risk its funds to make a loan that can be wiped out after the fact based solely on a difference of opinion on the benefit of the loan to the borrower.
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No matter how much the original rationale for the FTC’s Holder Rule may resonate today, the new state and local antipredatory laws have gone too far. The assignee liability provisions of these laws are not persuading loan purchasers to reallocate the cost of lender misconduct to the originating creditors. Instead, they are persuading the capital markets to abandon the mortgage marketplace. Robin Hood never played well on Wall Street.

Kirkpatrick & Lockhart LLP was founded in 1946, and, with more than 700 lawyers, is one of the 50 largest law firms in the United States. K&L attorneys are based in ten offices in key U.S. 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, brokerdealers, 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 subordinatelien residential mortgage loans, as well as open-end 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
Phillip L. Schulman 202.778.9027 pschulman@kl.com
Laurence E. Platt 202.778.9034 lplatt@kl.com
Costas A. Avrakotos 202.778.9075 cavrakotos@kl.com
Melanie Hibbs Brody 202.778.9203 mbrody@kl.com
Steven M. Kaplan 202.778.9204 skaplan@kl.com
415.249.1023 jjaffe@kl.com
Jonathan Jaffe
H. John Steele 202.778.9489 jsteele@kl.com
R. Bruce Allensworth 617.261.3119 ballensworth@kl.com
Irene C. Freidel
Daniel J. Tobin
617.261.3115 ifreidel@kl.com
202.778.9074 dtobin@kl.com
Jerome Walker 212.536.4850 jwalker@kl.com
Nanci L. Weissgold 202.778.9314 nweissgold@kl.com
Phillip John Kardis II 202.778.9401 pkardis@kl.com
David L. Beam
Emily J. Booth
Krista Cooley
Eric J. Edwardson
202.778.9026 dbeam@kl.com
202.778.9112 ebooth@kl.com
202.778.9257 kcooley@kl.com
202.778.9387 eedwardson@kl.com
Suzanne F. Garwood 202.778.9892 sgarwood@kl.com
Laura A. Johnson
Kris D. Kully
Christopher G. Morrison 202.778.9245 chris.morrison@kl.com
Erin Murphy
Lorna M. Neill
Sam A. Ozeck
Holly M. Spencer
202.778.9249 laura.johnson@kl.com
202.778.9301 kkully@kl.com
415.249.1038 emurphy@kl.com
202.778.9216 lneill@kl.com
202.778.9085 sozeck@kl.com
202.778.9853 hspencer@kl.com
DIRECTOR OF LICENSING
Stacey L. Riggin 202.778.9202 sriggin@kl.com
REGULATORY COMPLIANCE ANALYSTS
Dana L. Lopez
Nancy J. Butler
Susan C. Curtin
Joelle Myers
202.778.9383 dlopez@kl.com
202.778.9374 nbutler@kl.com
202.778.9337 scurtin@kl.com
202.778.9093 jmyers@kl.com
Marguerite T. Frampton 202.778.9253 mframpton@kl.com
Jeffrey Prost 202.778.9364 jprost@kl.com
202.778.9219 pmesa@kl.com
Patricia E. Mesa
Kenasha Scott
Heidi M. Evans
202.778.9384 kscott@kl.com
202.778.9241 hevans@kl.com
Allison A. A. Rosenthal 202.778.9894 arosenthal@kl.com
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