FYI: 3rd Cir Rejects Challenge to Parallel State AG and CFPB Prosecutions

The U.S. Court of Appeals for the Third Circuit recently affirmed the denial of a motion to dismiss filed by a federal student loan lender and servicer against claims raised by the Commonwealth of Pennsylvania alleging violations of federal and state consumer protection laws after the Consumer Financial Protection Bureau filed suit raising similar claims.

 

In so ruling, the Third Circuit held that the Commonwealth's parallel enforcement action under the federal Consumer Protection Act of 2010 was permitted by the statute's plain language, and the federal Higher Education Act of 1965 does not expressly preempt the Commonwealth's claims under Pennsylvania's Unfair Trade Practices and Consumer Protection Law to the extent they are based on affirmative misrepresentations and misconduct, rather than failures of disclosure, and no other preemption principle barred the Commonwealth's claims.

 

A copy of the opinion is available at:  Link to Opinion

 

In January 2017, the Consumer Financial Protection Bureau ("CFPB"), along with the States of Illinois and Washington filed similar lawsuits against a prominent federal student loan lender and servicer ("Servicer") alleging, among other things, that it supposedly failed to adequately disclose the availability of income-driven repayment (RPA) programs to borrowers, instead steering its borrowers into forbearance to their detriment by adding interest to the loan's principal and losing credit for months that would have been counted towards forgiveness. 

 

Nine months later, in October 2017, the Commonwealth of Pennsylvania (the "Commonwealth") filed similar claims against the Servicer, alleging violations of the Pennsylvania's Unfair Trade Practices and Consumer Protection Law, 73 Pa. Const. Stat. §§ 201, et seq. (the "PA Protection Law") for supposedly unfairly and deceptively originating risky, expensive loans, which had a high likelihood of default, among other unlawful conduct; the PA Protection Law for allegedly steering borrowers suffering long-term financial hardship into costly forbearances; the Consumer Protection Act for allegedly steering borrowers suffering long-term financial hardship into costly forbearances; the PA Protection Law for alleged loan servicing failures related to recertification of IDR plans; the Consumer Protection Act for alleged loan servicing failures related to recertification of IDR plans; the PA Protection Law for alleged misrepresentations relating to cosigner releases; the Consumer Protection Act for alleged misrepresentations relating to cosigner releases; the PA Protection Law for alleged repeated payment processing errors; and the Consumer Protection Act for the same alleged repeated payment-processing errors. 

 

The Commonwealth's complaint differed from the other actions in that it also challenges the pre-2007 loan origination practices of the Servicer's corporate predecessor (Count I), and its alleged "fail[ure] to disclose a date certain by which a borrower must submit materials to recertify an [IDR] plan." 

 

The Servicer moved to dismiss the Commonwealth's complaint for failure to state a claim arguing: (i) that the Consumer Protection Act of 2010, 12 U.S.C. § 5552, et seq. (the "Consumer Protection Act" or the "Act") precluded the Commonwealth from filing a concurrent, parallel enforcement action lawsuit, and; (ii) that the federal Higher Education Act of 1965, 20 U.S.C. § 1001 et seq., (the "Education Act"), preempts the Commonwealth's loan servicing claims under its Unfair Trade Practices and Consumer Protection, 73 Pa. Cons. Stat. §§ 201-1 to 201-9.3 Law (the "PA Protection Law").

 

These arguments were rejected by the trial court, which held (i) that Section 5552(a)(1) of the Consumer Protection Act, 12 U.S.C. § 5552(a)(1), unambiguously confers a right on state attorneys general to file suit to enforce the Consumer Protection Act, and that there is nothing in the Act that would bar a parallel state action; (ii) that the Commonwealth's action survived under express-preemption principles in that the claims were not an attempt to impose disclosure requirements on Navient, but were instead distinct allegations of unfair and deceptive business practices brought pursuant to Pennsylvania's traditional state police powers, and; (iii) that conflict preemption did not apply because uniformity was not an express goal of Congress in enacting the Education Act and, even if it were, this goal is not defeated by allowing the Commonwealth to enforce its consumer protection laws. Pennsylvania v. Navient Corp., 354 F. Supp. 3d 529, 543-53 (M.D. Pa. 2018).

 

The Third Circuit granted permission to appeal two of the three questions of law certified by the trial court for interlocutory appeal: (1) whether the Commonwealth may bring a parallel enforcement action under the Consumer Protection Act after the Bureau has filed suit; and (2) whether the Education Act preempts the Commonwealth's loan-servicing claims under the PA Protection Law.

 

Turning first to the issue of whether the Consumer Protection Act barred concurrent actions, the Third Circuit noted that the plain language of Section 5552 permits the attorney general of any state to bring a civil action to enforce provisions of the Act.  12 U.S.C. § 5552(a)(1). Moreover, while other provisions of the Consumer Protection Act expressly prohibit concurrent claims, section 5552 does not. 

 

While the Servicer correctly pointed out that section 5552(b) requires state attorney generals to notify the CFPB before filing such a lawsuit (12 U.S.C. § 5552(b)(1)(A)) and grants the Bureau authority to intervene in such lawsuits (12 U.S.C. § 5552(b)(2)(A)), the Third Circuit concluded that the pre-suit notice requirement does not negate that statute's express authorization of parallel state actions, and the Servicer failed to provide any case law authority supporting that, where a statute allows third-party intervention, concurrent claims are barred. 

 

Lastly, the Third Circuit held that the trial court correctly rejected the Servicer's augment that allowing concurrent claims would overburden the courts, because although "federal courts are indeed inundated with cases, adjudicating this case is a burden the Court is required to assume, absent a recognized statutory or procedural basis that precludes the Commonwealth from bringing its action." Navient, 354 F. Supp. 3d at 546.

 

Accordingly, the Third Circuit held that the clear statutory language of the Consumer Protection Act permits concurrent state claims, for nothing in the statutory framework suggests otherwise.

 

Next, the Third Circuit reviewed the Servicer's argument that the Commonwealth's action was preempted, both expressly and impliedly by the federal Education Act.  As you may recall, The Supremacy Clause of the Constitution, U.S. Const. art. VI, cl. 2, invalidates any state law that "interferes with or is contrary to federal law[.]" Free v. Bland, 369 U.S. 663, 666 (1962). 

 

In preemption cases, "[the Court's] inquiry is guided by two principles.  First, the intent of Congress is the 'ultimate touchstone' of preemption analysis… Second, [Courts] 'start[] with the basic assumption that Congress did not intend to displace state law.'"  Farina v. Nokia Inc., 625 F.3d 97, 115-16 (3d Cir. 2010) (quoting Medtronic, Inc. v. Lohr, 518 U.S. 470, 485 (1996)).

 

The Servicer argued that Counts II and IV of the Commonwealth's Complaint challenging the sufficiency of the Servicer's "disclosures" or "notice" required under the PA Protection law are expressly preempted by Section 1098 of the Education Act which provides that "[l]oans made, insured, or guaranteed pursuant to a program authorized by Title IV of the Higher Education Act . . . shall not be subject to any disclosure requirements of any State law." 20 U.S.C. § 1098g. 

 

Here, the Third Circuit determined that the Commonwealth's claims were not wholly based on failures of disclosure, but instead, sought to hold the Servicer accountable for its misconduct in making numerous affirmative misrepresentations. 

 

Following rulings from the Eleventh and Seventh Circuits, the Third Circuit adopted the distinction between affirmative misrepresentation and failure to disclosure information as required by the Education Act, concluding that Section 1098g does not expressly preempt claims to the extent they are alleging affirmative misrepresentations rather than failures of disclosure.  See Lawson-Ross v. Great Lakes Higher Educ. Cop., 955 F.3d 908, 917 (11th Cir. 2020) ("the precise language Congress used in § 1098g preempts only state law that imposes disclosure requirements; state law causes of action arising out of affirmative misrepresentations a servicer voluntarily made that did not concern the subject matter of required disclosures impose no disclosure requirements."); Nelson v. Great Lakes Higher Educ. Cop., 928 F.639, 650 (7th Cir. 2019) ("[w]e recognize that it would be possible to apply state consumer protection laws to impose additional disclosure requirements on loan servicers of federally insured student loans. Such applications would be preempted under § 1098g . . . . But that result is not necessary or 31 inherent in [the borrower's] claims, at least to the extent she alleges affirmative misrepresentations."). 

 

Accordingly, the Third Circuit concluded that the trial court correctly concluded that the Commonwealth's complaint alleges Navient made numerous affirmative misrepresentations, and claims based thereon are not expressly preempted by the Education Act.

 

The Appellate Court similarly rejected the Servicer's arguments that Section 1098g impliedly conflicted with the Commonwealth's state-law claims, finding no intent that Congress "had the sweeping goal of regulating all misconduct that could possibly occur in student loan financing and requiring uniformity of all claims tangentially related to the Education Act," and that, while not expressly argued by the Servicer, that the Education Act also does not field preempt the regulation of student loans.  Nelson, 928 F.3d at 651 ("'[S]tate law and federal law can exist in harmony' under the Education Act."); See, e.g., Lawson-Ross, 955 F.3d at 923; Nelson, 928 F.3d at 651-52; Chae, 593 F.3d at 941–42; Armstrong v. Accrediting Council for Continuing Educ. & Training, Inc., 168 F.3d 1362, 1369 (D.C. Cir. 1999); Keams v. Tempe Tech. Inst., Inc., 39 F.3d 222, 226 (9th Cir. 1994).

 

Accordingly, because the Commonwealth's action was not barred under the plain language of the Consumer Protection Act nor preempted by the Education Act, the trial court's denial of the Servicer's motion to dismiss was affirmed.  

 

 

 

Ralph T. Wutscher
Maurice Wutscher LLP
The Loop Center Building
105 W. Madison Street, Suite 603
Chicago, Illinois 60602
Direct:  (312) 551-9320
Fax: (312) 284-4751

Mobile:  (312) 493-0874
Email: rwutscher@MauriceWutscher.com

 

Admitted to practice law in Illinois

 

 

 

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FYI: 6th Cir Holds Lender Violated TILA's "Ability to Repay" Income Verification Rule

In an unpublished opinion, the U.S. Court of Appeals for the Sixth Circuit recently held that a mortgage lender's reliance upon borrower's representations concerning the amount of his future spousal support and rental income without proper verifiable documentation were insufficient to satisfy the "ability to repay" income verification requirements arising under the federal Truth in Lending Act, 15 U.S.C. § 1601, et seq. ("TILA"), and its implementing regulation ("Regulation Z").

 

However, the Sixth Circuit ruled in favor of the lender on the borrower's negligence, unclean hands, unconscionability, and recoupment claims.

 

A copy of the opinion is available at:  Link to Opinion

 

Prior to the finalization of a divorce proceedings between the borrower and his spouse, the borrower applied with the lender for a refinance of his existing mortgage loan in order to remove the spouse as an obligor on the existing loan.  In his loan application, the borrower claimed income from employment, social security, rental proceeds, and spousal support. 

 

For the spousal support income, the borrower and his spouse made various verbal representations to the lender in which they both promised that a separation agreement for the amounts claimed in the application would be executed by them.  This spousal support constituted a substantial portion of the borrower's income. 

 

The lender approved the borrower for the refinance loan based, in part, on the spousal support agreement provided by the borrower.  The agreement was not, in fact, executed by the borrower and his spouse until two months after the loan closed. 

 

The lender also relied upon the borrower's tax returns to verify the rental income claimed in the application.  However, the tax returns did not reflect the actual rental income amount claimed in the application and it did not pertain to the same property scheduled in the loan application.  The lender did not review any lease agreements concerning the rental income claimed by the borrower.

 

After the loan origination, the borrower and his ex-spouse complied with the separation agreement for a few months, but the borrower ultimately broke from the separation agreement.  Instead of complying with the terms of the separation agreement, the borrower petitioned the divorce court for a greater award of spousal support. 

 

The trial court denied the borrower's petition, and the final divorce decree awarded the borrower only a fraction of the agreed upon spousal support provided for in the separation agreement.

 

The borrower fell into arrears on the refinance loan and defaulted some two years after its origination. Following his default, the borrower filed a complaint against the lender alleging that the lender violated TILA by extending the loan without a reasonable and good-faith determination that he had a reasonable ability to repay the loan and failing to verify his income.  The borrower also brought a negligence claim against the lender for extending the loan.

 

After the borrower filed his complaint, the lender initiated a separate proceeding to foreclose on the loan.  That separate proceeding was dismissed, and the lender was provided leave to amend its answer in the present matter to include a counterclaim for foreclosure and breach of contract.

 

Following the filing of cross motions for summary judgment, the trial court granted judgment in favor of the lender and against the borrower on his claims for violations of TILA and for negligence.  The lower court also granted judgment in favor of the bank on its claims for breach of contract and issued a foreclosure decree.

 

The borrower appealed.

 

As to his TILA claims, the borrower argued on appeal that the lender failed to comply with TILA because his spousal support income was not documented or verified as required by TILA and its implementing regulations. 

 

As you may recall:

 

-  Section 1639c of TILA provides in relevant part that: "no creditor may make a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan…"  15 U.S.C. § 1639c(a)(1). 

 

-  TILA further provides that in making a determination as to the consumer's ability to repay, the creditor "shall include consideration" of among other things "the consumer's credit history, current income, expected income the consumer is reasonably assured of receiving…" 15 U.S.C. § 1639c(a)(3). 

 

-  TILA requires that the creditor verify the income sources through a review of numerous documents including the consumer's tax returns, payroll receipts, or "other third-party documents that provide reasonably reliable evidence of the consumer's income or assets".  15 U.S.C. § 1639c(a)(4).  Regulation Z provides additional clarification on the incomer verification and ability to repay requirements. 

 

-  TILA and Regulation Z provide for both a conclusive and a rebuttable presumption of the ability to repay for certain "qualified mortgages" under 15 U.S.C. § 1639c(b) and 12 CFR § 1026.43(e).

 

The Court found that 12 C.F.R. § 1026.43 and Appendix Q to Regulation Z were particularly relevant to the claims.

 

The Sixth Circuit noted that a determination that a loan is a "qualified mortgage" under Regulation Z can result in either a conclusive or rebuttable presumption that the lender complied with the reasonable-ability-to-repay requirement.  See 12 C.F.R. § 1026.43(e)(1).  However, the lender did not claim that the loan was a "qualified mortgage" or that it was otherwise entitled to the presumption.

 

Appendix Q generally requires that a creditor verify that spousal-support payments have "been received during the last 12 months" to include those in a consumer's income calculation.  But, Appendix Q allows for a creditor to rely upon "evidence that spousal support payments have been received" for "[p]eriods less than 12 months …, provided the creditor can adequately document the payer's ability and willingness to make timely payment."  App. Q § II(A)(3).  Appendix Q further requires that for spousal support income to be effective, the consumer must provide required documentation which may include a final divorce decree, legal separation agreement, court order or voluntary payment agreement.  Id.

 

Notwithstanding the issues as to whether or not Appendix Q even applied in this instance, which the Sixth Circuit did not resolve, the Court determined the lender failed to comply with Appendix Q because at the time of origination for the refinance loan, the borrower had not received any spousal support payments. 

 

The Sixth Circuit also found that the borrower's ex-spouse's verbal promises to enter into the separation agreement clearly did not meet the required document criteria. 

 

Similar to Appendix Q, section 1026.43(c) of Regulation Z requires the creditor to use "third-party records that provide reasonably reliable evidence of the consumer' income or assets."  12 C.F.R. § 1026.43(c)(2)(i). A "third-party record" under Regulation Z is limited to: (i) "a document or other record prepared or reviewed by an appropriate person other than the consumer, the creditor, or the mortgage broker … or an agent of the creditor or mortgage broker;" (ii) a copy of the consumer's state or federal tax returns; (iii) business records from the creditor for the consumer's account; (iv) if the consumer is an employee of the creditor or mortgage broker, then the consumer's employment records are allowed.  12 C.F.R. § 1026.43(b)(13).

 

The Sixth Circuit soundly rejected the lender's argument that it complied with the requirements of Section 1026.43 by reliance upon the representations of the borrower and his ex-spouse.  The verbal promises did not meet the definition of required documentation under Appendix Q or a "third-party record" because as the Court noted, it was not any agreement or document at all, and the lender did not present any argument to explain how it believed that these representations met this criteria. 

 

Accordingly, the Court found that the lender violated TILA and Regulation X in its handling of the spousal income.

 

The Sixth Circuit was not persuaded by the lender's argument that its reliance upon these representations was justified because it was in fact executed and the borrower and his ex-spouse did perform under that agreement.  As noted by the Court, "[a]lthough the [lender's] arguments are sympathetic, they do not change the fact that technical violations of TILA generally result in liability."  Putle v. Eldridge Auto Sales, Inc., 91 F.3d 797, 801-02 (6th Cir. 1996). Thus, the Court determined that the lender's good faith efforts and the borrower's actions in reneging on the separation agreement did not provide a defense or justification for the lender's violation of TILA. 

 

The Court also determined that the lender violated the income verification requirements pertaining to the borrower's rental income.  Specifically, the lender failed to obtain copies of the lease agreement to verify that his claimed rental income was accurate, and as the Court noted, the amount of the borrower's actual rental income at the time of the origination was lease than what he claimed on his application.  Instead, the lender merely relied upon tax returns which showed a different amount of rental income and for different properties. 

 

The Sixth Circuit found that this was a violation of lender's requirement to verify the sources of the claimed rental income as provided for in Section 1024.36(c)(3) and (4) of Regulation Z.

 

Accordingly, the Court reversed the trial court's summary judgment orders on the borrower's TILA claim, and remanded the matter for further proceedings.

 

As to the borrower's negligence claim, the Sixth Circuit agreed with the trial court that the borrower failed to establish that the lender owed him any duty.  As stated by the Court, "Ohio law provides that lenders owe no duty to prospective borrowers during negotiations about terms and conditions of a loan."  Blon v. Bank One, 519 N.E.2d 363, 368 (Ohio 1998); Shaner v. United States, 976 F.2d 990, 993 (6th Cir. 1992). 

 

The Court rejected the borrower's argument that TILA provided a duty on which it could premise his negligence claim, determining that it could not find any Ohio case which supported his argument and that "when given a choice between an interpretation of [state] law which reasonably restricts liability and one which greatly expands liability, we should choose the narrower and more reasonable path."  Combs v. Int'l Ins. Co., 354 F.3d 568, 577 (6th Cir. 2004). 

 

Accordingly, the Sixth Circuit affirmed the lower court's entry of summary judgment in favor of the lender on the negligence count.

 

The borrower further argued on appeal that the trial court's judgment in favor of the lender on its foreclosure claim was in error because he had valid defenses to foreclosure in the form of unclean hands, unconscionability, and recoupment or setoff. 

 

The Sixth Circuit found that the evidence in the record did not rise to the level of unclean hands which under Ohio law required a showing that the lender's conduct was reprehensible.  Basil v. Vincello, 553 N.E.2d 602, 607 (Ohio 1990).  As noted by the Court, although the lender failed to verify his income as required by TILA, the borrower himself signed the application confirming that the income was accurate, and the lender gathered and reviewed many standard loan-file documents including tax returns and bank statements. 

 

Similarly, the Court found that the evidence did not support a claim for unconscionability.  The borrower argued the lender engaged in prohibited "mortgage flipping" which is an unconscionable act under Ohio law.  See Ohio Rev. Code Ann. § 1345.031(B)(12).

 

The Sixth Circuit was not persuaded by the borrower's argument, however, as the terms of the refinance loan were not demonstratively worse than the prior loan.  As noted by the Court, although the interest rate was slightly higher on the refinance loan, it resulted in a lower monthly payment for the borrower.  The Court also found persuasive the fact that the refinance was extended based upon representations from the borrower and his ex-spouse that it was required to facilitate their separation agreement, not as a plot by the lender to saddle the borrower with debt and to strip the equity from the property. 

 

The Court also found that the borrower's claim for recoupment was without merit.  As noted by the Court, under TILA, recoupment or setoff is "a matter of defense" to foreclosure, and recovery is limited to the "amount to which the consumer would be entitled under [§ 1640(a)] for damages for a valid claim brought in an original action against the creditor."  15 U.S.C. § 1640(k)(1) & (2).  Because the borrower brought his own original claim against the lender for a violation of TILA, he cannot also assert recoupment as defense as this would result in an award of double damages. 

 

However, the Sixth Circuit found that the damages that he is awarded for a violation of TILA under Section 1640(a) can be applied as a set-off against the amount due in the foreclosure. 

 

Accordingly, the Sixth Circuit did not reverse the trial court's judgment as to foreclosure or breach of contract in favor of the lender, but it remanded these claims to be considered for a determination of damages under the borrower's TILA claim and for further proceeding consistent with its opinion. 

 

 

 

Ralph T. Wutscher
Maurice Wutscher LLP
The Loop Center Building
105 W. Madison Street, Suite 603
Chicago, Illinois 60602
Direct:  (312) 551-9320
Fax: (312) 284-4751

Mobile:  (312) 493-0874
Email: rwutscher@MauriceWutscher.com

 

Admitted to practice law in Illinois

 

 

 

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FYI: 3rd Cir Upholds Challenge to Securitization Trusts' Appointment of Additional Servicer

The U.S. Court of Appeals for the Third Circuit recently held that six Delaware asset securitization trusts could appoint an additional servicer to collect loans in default, but violated the trust documents by transferring to the beneficial owners powers reserved for the trustee.

 

The Third Circuit also held that the agreement appointing the additional servicer was invalid because it modified the underlying trust documents and thus required the trustee's and noteholders' consent.

 

A copy of the opinion is available at:  Link to Opinion

 

The six trusts were created between 2003 and 2005 under the Delaware Statutory Trust Act. The trusts each issued notes (the "Notes") entitling their holders (the "Noteholders") to the income from the student loans purchased with Note proceeds. To secure the Notes, the Trusts pledged the student loans under a "Granting Clause" in documents called "Indentures" entered into with a national bank as "Indenture Trustee." 

 

"The Trust Agreements appointed an owner trustee (the "Owner Trustee") to act for and manage the affairs of each Trust. The Owner Trustee in turn appointed an administrator (the "Administrator") to aid it in discharging its duties and to take certain actions under an administration agreement (the "Administration Agreement")."

 

"To fund the acquisition of the student loans, the Trusts issued Notes to the Noteholders. The Notes are backed by the loans and are paid through principal and interest payments received from student loan borrowers."

 

The parties to the Administration Agreement for each trust were the Owner Trustee, a national bank as "Indenture Trustee" a limited liability company as "Depositor", and a corporation as Administrator.

 

The Granting Clause of the Indentures transferred to the Indenture Trustee not only the student loans securing the Notes, but also  "all Servicing Agreements and all Student Loan Purchase Agreements, including the right of the Issuer to cause the Sellers to repurchase[,] or the Servicer to purchase, Student Loans from the Issuer…."

 

The Indentures also required the Trusts to "maintain an arm's length relationship with … of any the [Trusts'] Affiliates" and "avoid the appearance of conducting business on behalf of any Owner or any Affiliate of an Owner … [and] require[d] the consent of Noteholders and the Indenture Trustee in order to 'waive, amend, modify, supplement or terminate' and of the Basic Documents."

 

At the outset, the trust documents only provided for the servicing of performing student loans, not those in default, because the loans were guaranteed by a Pennsylvania agency. However, in 2008 that entity went bankrupt, and in 2009 the Trusts "entered into a 'Special Servicing Agreement' [with a third party (the "Special Servicer")] for the purpose of servicing two categories of non-performing student loans, 'Defaulted Loans' and 'Delinquent Loans.'" The Special Servicing Agreement provided that the Indenture Trustee would replace the Special Servicer if the latter resigned.

 

In 2012, the Special Servicer "was sold" and it resigned, thus making the Indenture Trustee the Special Servicer.

 

During the Indenture Trustee's tenure as Special Servicer, the Trusts alleged that "over $1 billion of loans … bec[a]me uncollectable due to the expiration of the relevant statute of limitations and over $4 billion of loans … defaulted [and] [t]he trusts are paying servicing fees in excess of any revenues they can collect on the Defaulted Loans."

 

"In addition, lawsuits filed by [the Indenture Trustee acting as Special Servicer] against borrowers for collection on Defaulted Loans were dismissed due to faulty documentation and procedures, and subsequently the Trusts were sued in both class action suits and by individuals for illegal collection practices."

 

The Owners then hired a third loan servicer in 2014 in order to "mitigate losses" (the "Odyssey Agreement"). At that time, "the beneficial owners of the Trusts were an affiliate of [a national bank] and an affiliate of [the entity named as] "the authorized representative of the Owners in connection with the … transaction." In 2017, one of the member-owners of the third loan servicer resigned, leaving the remaining member as "the majority equity owner of the Trusts and the only owner of [the third servicer, leaving] one entity doing the pooling and the servicing of the student loans."

 

The Trusts then asked the Indenture Trustee to approve the hiring of the third loan servicer, but it refused, arguing that "the Odyssey Agreement unilaterally, and thus impermissibly, amended the Basic Documents" and was thus incompatible with the Special Servicing Agreement.

 

"In December 2015, the Trusts submitted more than $1.24 million in invoices from the [third loan servicer] for payment from the Indenture Trust Estate … [for] services such as conducting audits and other work to evaluate which Defaulted Loans could be sold." The Administrator "refused to process the invoices and requested additional information[,][sending] the invoices to [the] Indenture Trustee, complaining that no documentation was provided for the alleged expenses."

 

In 2016, the Indenture Trustee filed suit in state court seeking a declaratory judgment whether the third servicer was improperly appointed, invalidating the Odyssey Agreement "because it would amend or modify the [trust documents], and whether the invoices submitted [under the Odyssey Agreement] should be paid."

 

The Trusts removed the case to the federal court, and the matter was later transferred to a trial court in the Third Circuit. After discovery, the parties filed cross-motions for summary judgment.

 

The federal Magistrate Judge issued Report and Recommendation ("R&R"), recommending that the trial court "grant the Trusts' motion for summary judgment, deny [the Indenture Trustee's] motion, and order that the Odyssey invoices be paid."

 

The Indenture Trustee and the Noteholders filed objections to the R&R.  In response, the Trusts argued "that most of their objections raised new argument not presented before the Magistrate Judge, including that the Granting Clause precluded the Trusts from hiring [the third servicer]."

 

The trial court "essentially adopted the R&R in its entirety and held that arguments not presented to the Magistrate Judge were waived."

 

On appeal, the Third Circuit began by discussing the standard of review, explaining the difference between interpretation and construction of a contract. "[C]ontract interpretation if a question of fact review for clear error and construction is a question of law reviewed de novo. … Contract interpretation involves determining the meaning of the contract language and giving effect to the parties' intent. … Construction of a contract goes beyond interpretation and requires determining the legal effect and consequences of contractual provisions."

 

The Court then found that the case before it raised issues of contract construction because the meaning of particular terms was not disputed. Instead, it had "to determine the legal effect of and interplay between various provisions of the [trust documents] and the Odyssey Agreement."

 

The Third Circuit agreed with the Indenture Trustee and the Noteholders that the Odyssey Agreement violated the Indentures' Granting Clause, "not because the plain language of the Granting Clause prohibits the Trusts from appointing a new servicer, but rather because the Odyssey Agreement specifically assigned to the Owners of the Trusts several rights reserved for the Indenture Trustee, for the benefit of the Noteholders" in the trust documents.

 

The Court rejected the Trusts' argument that the Indenture Trustee and the Noteholders "waived their argument that the Granting Clause precludes the Trusts from entering into the Odyssey Agreement." First, the Court reasoned, "the Trusts misrepresent that the [trial court] held that the Granting Clause argument was waived" because it expressly held "that 'the granting clause does not preclude the trusts from appointing new servicers.' It recited the standard for waiver but "did not hold that there was waiver."

 

Second, the Third Circuit reasoned, "the Noteholders argued to the Magistrate Judge 'that the Odyssey Agreement violates the grant of the Indentures,' … and joined [the Indenture Trustee's] submissions on summary judgement, which include arguments that the Odyssey Agreement violated the Clause." Thus, the Court found that "[o]n this record, the Trusts cannot claim the Granting Clause argument surprised them."

 

Finally, the Court reasoned, "even if [the Indenture Trustee and the Noteholders] had not clearly raised the argument, we have discretion to consider whether the Odyssey Agreement contravenes the Grant of the Indenture (something we would do if needed), which presents a 'pure question of law…."

 

Next, the Third Circuit found that the plain language of the Granting Clause did not prohibit the Trusts from appointing a new servicer because the language was not absolute and did not "divest the Trusts of their power and responsibility to appoint servicers."

 

In addition, the Court noted, the Trusts retained certain obligations under the trust documents, including the "obligation 'to enter into such agreements that are necessary' to 'provide for … the servicing of the Student Loans" and the Granting Clause stated that 'none of the obligations' of the granting party are transferred…." The Third Circuit held that "reading the Granting Clause here to prevent the Trusts from hiring a new Servicer would render meaningless" the other provisions of the Trust Agreements …, including, inter alia, their right and power to hire, designate, and appoint the Special Servicer …, to direct audits on behalf of the Trusts, … and to protect the Trusts and take action if they become aware of a servicer default…."

 

"Because the Granting Clause does not state that it divests the Trusts of their power and obligation to appoint servicers and because interpreting the Clause to do so would render several other provisions of the Basic Documents not effective," the Court held that "the Granting Clause does not categorically prohibit the Trusts from appointing another servicer."

 

The Third Circuit cautioned, however, that "[t]his conclusion does not end our analysis" because the fact that "the Trusts still have authority to appoint a new servicer does not mean that the Odyssey Agreement specifically does not violate the Granting Clause."

 

The Court then agreed with the Indenture Trustee's and the Noteholders' argument that "the Odyssey Agreement impermissibly reserved for the Trusts several rights that the Granting Clause conveyed to the Indenture Trustee, including, among other things, the right to replace [the third servicer] for cause …, and the right to direct [it] to act free from liability to the Indenture Trustee…."

 

In addition, the Third Circuit found that "the Odyssey Agreement impermissibly modified and supplemented the Basic Documents" without the Indenture Trustee's and Noteholders' consent, holding that "the District Court's conclusion [to the contrary] contravenes well-settled New York law … [u]nder [which] parties to contracts cannot do anything that 'will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.'"

 

In particular, the Odyssey Agreement "had the effect of altering the Basic Documents even if there was no formal amendment" because it allowed the third servicer "to purchase Defaulted Loans at a 'purchase price' that is 10% less than fair market value of the Defaulted Loan, in other words, to retain a 10% commission for arranging for the sale of the Loan."

 

The Third Circuit went on to list "several additional provisions of the Odyssey Agreement that modified the terms" of the trust documents without the required consent of Indenture Trustee and Noteholders before holding that "the Odyssey Agreement violated the Granting Clause and the Consent Clause" of the Indentures.

 

Finally, because the trial court did not "consider whether the invoices would be payable if the Odyssey Agreement were invalid and thus void[,]" the Third Circuit remanded the case for the trial court "to decide in the first instance whether Odyssey's invoices are payable."

 

 

 

Ralph T. Wutscher
Maurice Wutscher LLP
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