Mortgage Servicer Privity with Borrowers

A lot of the mortgage servicing litigation over the past seven years has faltered on standing issues. Does the borrower have standing to sue the servicer? This has been a problem for RESPA and HAMP suits, where there are questions about whether there is a private right of action, as well as for plain old breach of contract actions. The point I make in this post is that borrowers almost always have standing to sue the servicer for a breach of contract action arising out of the mortgage loan contract itself because the servicer is an assignee of part of the mortgage note. This was an issue that lurked in the background of a case I recently testified in, and I think it's worth highlighting for the Slips readers.  

A lot of courts have misunderstood the nature of the servicing relationship vis-a-vis the borrower and assumed that because the servicer is not expressly a party to the note and security agreement that there is no privity between the borrower and servicer and hence the borrower cannot maintain a breach of contract suit.  That's wrong. The servicer is not on the note or the security agreement, but the servicer is an assignee of the note, just like the securitization trust, and that provides all the privity needed for a breach of contract suit.  

Legal scholarship has long understood that property can be conceptualized as a bundle of separate rights.  Thus, if I sell you Blackacre in fee simple, absolute, I am conveying to you the right to use Blackacre currently, the right to use it in the future, the right to the products and profits from the land, the right to reconvey it, etc. These rights could be split up:  I could sell you the right to use Blackacre for a year, with the property reverting to me thereafter.  That's just a lease.  Likewise, the mineral rights and the air rights to Blackacre could be sold separately from the surface rights. The same can be done with a mortgage note.

The mortgage note creates several rights for the lender:  a right to payment of principal, a right to payment of interest, a right to late fees, a right to reasonable attorneys fees, a right to sue, etc. That bundle of rights can be sold together, as in a fee simple, absolute transfer of real estate.  But it can also be split up, just like the various rights to Blackacre.  And that's exactly what happens with mortgage servicing contracts.  

Mortgage payments are made directly to the mortgage servicer. The servicer is then required to remit the payments to the mortgagee (or the investors in the mortgagee), but the servicer is entitled with retain certain funds as compensation, rather than remitting them.  In particular, servicing contracts typically compensate the servicer in three ways.

First, the servicer gets a servicing fee.  That servicing fee is calculated as a percentage of the outstanding principal balance of the loans serviced:  it's interest, typically 0.125%-0.5% of the interest payments on the loan get retained by the service.  So a slice of the interest paid on the mortgage is assigned to the servicer.  That's just as if the servicer were given a percentage of the proceeds of Blackacre.  

Second, the servicer is entitled to keep the "float" on the mortgage payments. The borrower pays the servicer on the 1st of the month, but the servicer might not be required to remit the funds to the mortgagee until the 25th of the month.  During the interim, the servicer gets to use the funds.  There are restrictions on how the servicer can use the funds, but basically, the servicer is given a rental of 300 days of mortgage payments a year, just as if it rented Blackacre for those 300 days.  Put together with the servicing fee, the servicer has the usefructs of the mortgage--it has the right to use it and to enjoy the profits. That's a real property right.  

Third, the service is entitled to keep any ancillary fees it collects. The mortgage note will itself specify the payment of late fees.  In most cases, servicers are entitled to retain all late fees. That's like getting the mineral rights to Blackacre. If the borrower doesn't pay the late fees, the servicer can sue for them, and the servicer should not be suing in the name of the mortgagee as the mortgagee has assigned all rights to the late fees to the servicer.  Same with reasonable attorneys' fees as provided for by the note, which the servicer recovers, rather than the mortgagee, assuming the servicer has engaged the attorney. 

Notice that all of this is a plain old property rights analysis of who gets what part of the mortgage note. It's totally missed by courts in a lot of opinions.  (In fairness, the fault might not be with the courts, but with the plaintiffs' attorneys for failing to understanding the privity case themselves. And there are also some opinions that either find some sort of equitable privity or which simply don't address the issue, but have rulings that are premised on privity.) This sort of contractual privity based on assignment is all separate from the privity created by a servicer's duties, such as property allocation of payments, or a servicer's activities, such as actually taking and collecting the borrower's check, determining the borrower's monthly payments (if there is an escrow required) and payoff amount, and being the point of contact with the borrower.  

Why does this privity matter?  It suggests that a borrower (or a class) has standing to challenge a servicer on breach of contract grounds for things such as unreasonable attorneys' fees, improper payment application.  It might also open the door for borrowers to sue servicers over loan modifications (or lack thereof) on the grounds of an implied duty of good faith and fair dealing.  By virtue of being the loan's partial assignee, the servicer picks up the obligations of the original lender, so there's no need to litigate over what duties the servicer owes as an agent of the noteholder.