An Article by Damon Ritenhouse and Prashant Vallury

This article explores the process of securitization in the mortgage industry and how it can be used to defend homeowners in foreclosure actions. Through analysis of a recent Illinois appellate case on the issue, the article gives practitioners a new strategy to help defend against trustee plaintiffs who may lack proper standing to bring a foreclosure suit.

Despite seeing a 44 percent drop over the last year, the overall rate of foreclosure filings in Illinois remains among the top six states nationwide. Illinois now sees one filing per every 682 housing units. Although this drop in filings does offer some hope that the foreclosure crisis is beginning to subside, it is important to note that approximately 35 percent of Chicago-area homeowners have a mortgage that is underwater, meaning that they owe more on their mortgage than the property is worth. Such a high volume of distressed properties could easily lead to increased foreclosure filings over the next several years.

In many Illinois jurisdictions, the overwhelming majority of homeowners facing mortgage foreclosure have no legal representation. In Cook County, thousands of foreclosures are processed annually, resulting in overwhelmed pro se homeowners being thrown into a system they often find bewildering.

There are a number of legal defenses available to a home¬owner facing a foreclosure action. Many of these stem from the impossibly complex paper trails that occurred when a homeowner’s note and mortgage were sold multiple times in the secondary market. From robo-signing to improper service of the summons, to alteration of affidavits by purported bank or servicer employees, to the absence of the required legal papers simply proving ownership by the bank or other foreclosing agent, many foreclosure suits are premised on flawed legal grounds.

This article focuses on the issue of standing in Illinois foreclosure lawsuits. It begins with a brief primer on the securitization and sale of mortgages. Next, it examines a recent Illinois appellate court decision that highlights the difficulties faced by homeowners challenging the standing of a plaintiff bringing a foreclosure against them. The last section discusses a new legal strategy that defense attorneys may be able to implement in an attempt to illuminate the improper practices of many foreclosing plaintiffs.

Securitization: How Mortgages Were Packaged and Sold on Wall Street

Asset-based securitization is not a novel concept to savvy financiers. However, the creation of a secondary market for residential home mortgages was a phenomenon that gained real traction in the 1970s, when several governmental agencies (Ginnie Mae, Fannie Mae, and the Federal Home Loan Mortgage Corporation) began purchasing bulk mortgages from the originators, creating pools of securities, and issuing these to investors.

Fundamentally, the goal of securitization is to turn illiquid assets (i.e., receivables) into a tangible product that can be sold to investors who seek a steady stream of returns on their investment. The illiquid assets are sold to an entity called a Special Purpose Vehicle (SPV), Special Purpose Entity (SPE), or a Special Purpose Corporation (SPC).

These structures are set up in a way that minimizes both bankruptcy risks and risk of failure. Subprime mortgages were often pooled together and sold into a trust by an originator. Branded with ratings issued by companies like Standard and Poor’s, these devices became highly sought after by a variety of investors, thus creating a much different mortgage market than had existed in years prior.

In the mid-1990’s, lenders began issuing large numbers of mortgages to borrowers with sub-standard credit. Lenders issued them to borrowers who, for reasons such as poor credit or fluctuating income, would not qualify for the more traditional mortgages.
To allow for the higher risks associated with issuing subprime mortgages, the upfront and maintenance fees associated with these loans would be higher compared to traditional mortgages. Further, a sizable majority of these loans tended to be adjustable-rate (“ARM”) mortgages, which could lead to monthly payments skyrocketing after a short “teaser” period of artificially low interest rates.9
The securitization process was extremely risky because the success of the system was almost entirely tethered to home values greatly increasing. When the housing market crashed, so did many of the banks that issued or invested in these loans. Homeowners were defaulting at alarming rates.

In a large majority of cases, the actual owners of the loans are no longer the original lenders. Rather, they are often private individuals or corporations that invested in the securities into which the loan was pooled. As the loans defaulted in record numbers, it was often servicers and trustees bringing the foreclosure actions, rather than the true owners. Thus the issue of standing arises.

Standing to maintain a foreclosure suit in Illinois

Before bringing an action to court, a party must demonstrate they have “standing.” Put another way, they must bear some adequate connection to the “harm” that can be redressed by the court. The general rule is that to properly bring a foreclosure, the party foreclosing must actually have the right to do so. An assignee of an original lender will generally lack standing unless the assignment was properly completed prior to the filing of the foreclosure action. However, even when many plaintiffs have difficulties in proving proper ownership, they are often allowed to proceed with foreclosure suits. In Illinois, standing requires proof of “some injury in fact to a legally cognizable interest.” It is required under the Illinois Constitution in order to have proper subject matter jurisdiction over a case. Standing is no mere procedural technicality. It is a core component of justiciability that vests a court with subject matter jurisdiction over a matter.

A number of Illinois appellate cases deal with the concept of standing in the foreclosure context, but one of the most recent provides insight into perhaps the most complex aspect of standing, involving a defendant’s ability to challenge the actions of a trust to which it is not a party.

Bank of America v. Bassman: a standing-challenge defeat for defendants

Recently, the second appellate district decided Bank of America v. Bassman.” In Bassman, the plaintiff was acting as a trustee on behalf of certain certificate-holders who alleged the right to foreclose on two commercial mortgages.

As an initial matter, there was a question as to whether Illinois or New York law would control in this matter. Although the court stated that the defendants could not properly invoke the choice-of-law provision contained in the trust documents, they ultimately decided that since the trust documents governing the transaction contained a provision invoking New York law, it should be used to determine if the mortgages were validly transferred into the trust.

The defendant’s primary argument was that the mortgages were never validly transferred into the trust and, as a result, the plaintiff did not have proper standing to bring the foreclosure. The plaintiff contended that the defendant lacked standing to challenge the actions of a trust to which it was not a party. The court conducted a lengthy analysis of mostly foreign precedent in resolving this issue.

The analysis began by looking at cases cited by the plaintiff where courts held that defendants did not have standing to challenge the actions of a trust to which it had no relationship. The court then cited to and discussed several cases where third parties had been allowed to challenge assignments to a trust where the transfer was void, rather than voidable. There was also an examination of a New York statute that declared transfers to be void when they were conducted in contravention of the trust documents.

The court then went on to look at other New York cases that found such ultra vires acts were merely voidable as opposed to being void. The primary thrust of these cases was that shareholders or other beneficiaries could have conceivably ratified the act done in derogation of the trust documents.

The court noted that tension existed between the cited statute and cases supporting the notion of voidness as opposed to the cases that held such transfers were simply voidable. However, the court declared this to be an issue for New York courts to resolve and that the existence of the line of cases finding theoretical ratification enough to make an act voidable was sufficient to support their finding that the defendants did not have standing to challenge the actions of the trust.

The court ultimately found against the defendant in this instance. However while they seemed to close the door on the ability of defendants to challenge the actions of the trust, they may have opened a window with their assertion that only void acts of a trust may be challenged. The court was adamant that actual ratification was not necessary, only the possibility of ratification.

Thus, the key to demonstrating the necessary standing to challenge the acts of the trust seems to be making a clear showing that the consequences of ratification would be so severe that no reasonable beneficiary would ever do so under any circumstances. If this showing can be made, the transfer would be void from its inception, rendering it open to attack by a defendant homeowner.

Challenging a trustee plaintiff’s lack of standing to bring a foreclosure suit

It is clear from the case discussed above that a defendant who comes into any foreclosure case with a standing defense faces a very difficult path. This is particularly true where the defense relies on challenging the actions of a trustee plaintiff who is asserting its alleged right to foreclose. Attorneys representing the trustee banks are sure to use the Bassman case in an attempt to rebut even the strongest evidence of fraud and impropriety. It will require innovation and creative legal thinking to combat this and persuade judges to move past the threshold issue of a defendant’s ability to challenge a trust.

This section will focus on a new strategy to assert when dealing with a trustee plaintiff. These plaintiffs are almost always foreclosing on behalf of a New York trust that is governed by a pooling and servicing agreement (PSA). The PSA is a complex document that contains very specific rules as to how the trust must conduct business. Importantly, this document must be filed with the Securities and Exchange Commission (SEC) and requires strict compliance.

The entity created and governed by the PSA is often known as a Real Estate Mortgage Investment Conduit (REMIC). A REMIC is a tax-advantaged class of investment that allows pools of mortgages to be created as an investment fund that is exempt from many types of income taxes.” To retain its tax-exempt status, a REMIC must fully and completely follow the guidelines laid out in the PSA.

The arcane tax rules governing REMICs require that all mortgages be transferred to them on the dates that they are formed. There is a 120-day grace period for correcting any errors, and after that the rules strictly forbid acquiring any additional mortgages. The reason for this limitation is that REMICs are tax-exempt because they are considered vehicles for passive, static investments. If they were to continue buying and selling mortgages, they would be acting as ordinary businesses, which are required to pay income taxes.

If the IRS concludes that the REMIC investments failed to comply with strict requirements in the federal tax code, the REMIC would have to pay a 100 percent tax on the income from those investments. That means that the IRS could confiscate the full amount. Tax law experts have theorized that the REMICs also could be subjected to additional penalties for failing to file tax returns on the income.

It is these tremendous tax penalties that may provide the basis for homeowners to have the ability to challenge the standing of a trustee plaintiff. As trust documents are explicit in setting forth a method and date for the transfer of the mortgage loans to the trust and in insisting that no party involved in the trust take steps that would endanger the trust’s REMIC status, if the original transfers did not comply with the method and timing for transfer required by the trust documents, then such belated transfers to the trust would be void, not simply voidable.

As discussed in the Bassman decision above, the only time that a non-party to a trust may challenge actions taken by the trust, is when those actions are void. The Bassman court held that if a transfer of an asset into a trust could even conceivably be ratified by its beneficiaries, then the action is merely voidable and thus not subject to challenge by a non-party. Thus, the vital showing to be made is that no rational beneficiary of the trust would ever ratify the transfer of a non-performing asset into the trust after its closing date because to do so would jeopardize the preferential tax status of the REMIC and subject the beneficiaries to millions in tax liability.

If judges can be persuaded to allow defendants to challenge the actions of the trusts, it will open up a whole new avenue for defense attorneys to explore. If the foreclosing plaintiffs are forced to abide by their trust documents, it could invalidate an untold number of improperly transferred mortgages. This would be a major arrow in the quiver of lawyers who are seeking to defend their client’s homes from foreclosing plaintiffs who have no legal standing.

Conclusion

It is clear that foreclosures have hit Illinois homeowners extremely hard and, unfortunately, it does not appear that this trend is slowing down. Attorneys who wish to battle the various banks, servicers, and trusts bringing this wave of lawsuits must gain an understanding of this highly technical area of law.

Among the chief defenses available in these actions is a challenge to the plaintiff’s standing to maintain the foreclosure. When the loans have been packaged and sold in the manner described above, there are often major gaps in a plaintiff’s paperwork when it comes time to foreclose on the mortgage.

One critical way to exploit these gaps is to learn about the securitization process and use this knowledge to challenge plaintiffs when they file questionable documentation in support of a foreclosure complaint. The appellate courts have not made these types of challenges especially easy, but the practitioner who is willing to employ novel tactics such as invoking the fragile tax status of the trusts in question, may yet be able to shine a light on the murky processes that lead from billion dollar Wall Street investment vehicles into courtrooms across Illinois.