Does Denial of Loan Modifications Constitute A Violation of the Fifth Amendment?

by REIT Wrecks on January 7, 2010

These days, the only thing more cramped than a Hong Kong cemetery is office space for special servicers. Nevertheless, if you’re a borrower in trouble, it’s unlikely that you’ll be outnumbered. CMBS default rates ballooned by almost 500% in 2009, up from 1.21% in the beginning of 2009 to over 6% by the end of the year. According to Trepp, this is highest default rate since the inception of CMBS. Jefferies & Co estimates that the CMBS default rate could reach 9-14% by the end of 2010.

So the last thing a special servicer would want to hear is that a Federal District Court in California has opened the door to a novel new foreclosure defense related to constitutional law. While this case deals specifically with single family residential loans, the RMBS market is much larger than the CMBS market, and at least one far-reaching rule change – the IRS’s 2009 modification of the REMIC provisions – can be traced to controversy that first arose in the RMBS market.

The case involves non-judicial foreclosure proceedings on a single family home in Ramona, California. The borrower defaulted on the mortgage in November 2007. In February 2008, a notice of default was recorded and served. And in December 2008, a notice of sale was recorded and served, setting a date for the public auction of borrower’s home. The borrower has alleged that their Fifth Amendment rights to due process have been violated, and a federal court has refused to dismiss the case.

California is a non-judicial foreclosure state, which means that Newport Beach property flippers are generally not entitled to their day in court in the event of a mortgage default. However, this case challenges that notion (although it is limited in scope), and the court has agreed to postpone the sale of the lender’s collateral until the case is resolved. Translation: the defaulting borrower gets to live in their 2 bedroom, 1.5 bath bungalow with carport until whenever forever the case is decided.

The most interesting aspect of the case is that the borrower alleges that the lender violated their Fifth Amendment procedural due process rights, even though the Fifth Amendment only applies to governmental actions, not those of private corporations. The court, in refusing to dismiss the complaint, agreed that in some circumstances the Fifth Amendment does apply to private entities, so long as there is sufficient nexus between the government and the private entity.

There are four different tests used to determine whether private action can be attributed to the state: (1) public function; (2) joint action; (3) governmental compulsion or coercion; and (4) governmental nexus. The court said that “satisfaction of any one test is sufficient to find state action, so long as no countervailing factor exists.”

The court also said that the mere fact that a business is subject to extensive regulation is not sufficient to find joint action, but that because the case involves the Home Affordable Modification Program (“HAMP”), which is a federally funded program, there could be a nexus over and above just extensive regulation.

The court acknowledged that the facts developed through discovery may ultimately show that Plaintiff cannot establish a nexus. At this early stage in the litigation, the court did not have sufficient information to assess the government’s level of involvement in the administration of individual HAMP requests, as well as the financial arrangements 10% cumulative preferred between the government and the lender regarding HAMP. The case is unlikely to get very far, in my humble opinion, but it’s an interesting decision for interesting times. The full decision is posted on Foreclosure Combatant.

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