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   ARTICLE   |   From Scotsman Guide Residential Edition   |   June 2008

Brokers Face a New Fiduciary Duty

Here’s what one state is doing to mandate that brokers keep clients’ best interests in mind

r_2008-6_long_fudiciaryThe federal government and several states are proposing stricter mortgage-industry regulation. Some of these proposals focus on creating a fiduciary duty for mortgage brokers toward their clients. Some also propose increased criminal penalties for brokers who commit fraud or knowingly mislead borrowers and expand or clarify disclosure requirements.

On the national level, for instance, Congress is considering a number of proposals to increase broker legislation. The proposed laws include increasing continuing-education requirements, creating a national mortgage-broker database and instituting national licensing, among other things.

Washington State's New Licensing Rules 

Another bill that takes effect in Washington state this month — state Senate Bill No. 6471, an expansion of the state's Consumer Loan Act (CLA) — will affect mortgage-broker licensing. Here are some highlights:

  • Brokers who are solely licensed under the state's Mortgage Broker Practices Act (MBPA) can no longer originate their own loans. Under the new legislation, these brokers also must have a CLA license. CLA licensees may either originate their own loans or broker loans.
  • The Fannie Mae and Freddie Mac exemption from the MBPA has been eliminated. Previously, lenders that sold directly to Fannie Mae or Freddie Mac were exempt from licensing. The new bill requires companies that originate their own loans to be licensed under the CLA unless they make loans under state or federal laws that relate to banks, savings banks, trust companies or credit unions.
  • Licenses are not required for loan-originator employees. All independent-contractor loan originators must be licensed regardless of the license under which they work.

And as state mortgage regulations get stricter, Washington state is taking the lead. Two bills that take effect this month -- state Senate Bill No. 6381 and substitute state House Bill No. 2770 -- will change the manner in which mortgage brokers in the state do business dramatically. Through them, the state has implemented new requirements for brokers to act in the best interests of their clients and to ensure that they recommend the “right loans” for the “right borrowers.”

Brokers in Washington state, as well as those keeping an eye on regulations nationwide, would be wise to understand the changes, which affect the mortgage-broker industry greatly. Here’s what you should know about what the new regulations mean and how brokers can stay in compliance.

Creation of fiduciary duties

The most dramatic change for Washington-state mortgage brokers comes from state Senate Bill No. 6381. It establishes a fiduciary obligation to borrowers, fundamentally changing the relationship between brokers and borrowers.

This means that a mortgage transaction is no longer an arm’s-length transaction to protect brokers in case of litigation. Instead, brokers must take measures to ensure that borrowers understand the loan they receive, all the associated expenses and whether it is the best loan available for them, given their credit score and prudent underwriting standards.

This change dramatically impacts the manner in which brokers must do business for regulatory and civil-liability reasons. Before the creation of a fiduciary duty, borrowers were responsible for investigating the loan and essentially for protecting their own interests independently of the broker. Now, brokers are obligated to protect borrowers.

This impact is especially burdensome in the context of civil litigation. Basically, with a fiduciary duty, the burden of proof in a trial shifts to the broker. That is, borrowers need only accuse, and brokers must demonstrate that the accusation is untrue. Previously, borrowers would have to demonstrate the validity of their accusation.

Other highlights of the new law’s requirements mandate that brokers:

  • Must act in borrowers’ best interests with the utmost good faith and fair dealing toward them;
  • Must disclose any and all interests to borrowers that are used to facilitate their request. That is, brokers must explain and determine that borrowers understand how everyone in the process benefits from the transaction;
  • Must disclose to borrowers all material facts known to the broker that might reasonably affect their rights, interest or ability to receive the intended benefit; and
  • Must not steer or direct borrowers to accept a loan with a less-favorable risk grade than the grade they would qualify for under prudent underwriting standards. This is permitted, however, if borrowers are offered loan products within the risk category and choose the higher-risk-grade product after consideration.

Disclosures, policies and penalties

The state’s substitute House Bill No. 2770 makes a number of provisions of which brokers should be aware.

A major provision requires brokers to provide borrowers with a new and separate written disclosure within three days of receipt of a loan application. Brokers also must update that disclosure if there are any material changes in the loan or costs before closing.

All subsequent disclosures must be made within three days of the change or closing, whichever is sooner.

The new disclosure’s form and content will be determined by the state’s Department of Financial Institutions (DFI), which will adopt a rule that complies with the new law. As of press time, the rulemaking timeline has yet to be determined.

The new law has mandated the disclosure’s minimum requirements, however. First, the disclosure must be in plain language that is reasonable and understandable to borrowers without the help of third-party resources. It also must state:

  • Fees and discount points on the loan;
  • Interest rates of the loan;
  • All broker fees;
  • Yield-spread premiums (YSPs) stated in a dollar amount;
  • Whether there is a prepayment penalty;
  • Whether property taxes and insurance are to be escrowed;
  • Whether the loan payments will adjust at the fully indexed rates; and
  • Whether there is a price added or premium charged for loans based on reduced documentation.

Another provision of this bill requires Washington-state mortgage brokers to comply with internal policies and procedures set forth in the “Interagency Guidance Nontraditional Mortgage Product Risks” and the “Statement on Subprime Mortgage Lending,” which were created by a group of federal-government regulatory agencies -- the Conference of State Bank Supervisors, the American Association of Residential Mortgage Regulators and the National Association of Consumer Credit Administrators.

Their purpose is to increase regulatory oversight of nonprime mortgage products, such as interest-only loans, payment-option ARMs, nonprime ARMs, nonprime extended-amortization products, reduced-documentation products and simultaneous second-lien loans.

The state’s DFI will adopt rules to implement this requirement, but it is worthwhile to note what these rules will likely cover.

First, brokers’ internal policies and procedures must be in writing and must demonstrate that the brokers understand the responsibilities for covered transactions. In particular, they should cover: consumer contact; internal controls, monitoring and reporting; and requirements that promotional materials and other product descriptions provide information about costs, terms, features and risks that can help consumers select a product.

They also should address the broker’s adherence to the newly required disclosure form and provide general guidance of the disclosure policy to consumers, such as clear and balanced information about the relative risks of products offered.

These policies’ and procedures’ adequacy also will be measured against the new fiduciary duty.

Finally, the new state House bill also increases the criminal penalties for violation of certain aspects of the law. Under the Mortgage Brokers Practices Act, an act violation was a misdemeanor punishable by as many as 90 days in county jail and/or a $1,000 fine.

Under the new law, however, some of the violations now subject violators to a class-B felony charge that is punishable by as many as 10 years in state prison and/or a $25,000 fine, as well as civil forfeiture.

Brokers who commit one of the following violations, whether directly or indirectly, are subject to the new penalties.

  • Employing a scheme, device or artifice to defraud or materially mislead a borrower, lender or any person
  • Engaging in any unfair or deceptive practice toward any person in the lending process
  • Obtaining property by fraud or material misrepresentation in the lending process
  • Knowingly making any misstatement, misrepresentation or omission during the lending process with the knowledge that a lender, borrower or other party may rely on it
  • Using or facilitating the use of any misstatement, misrepresentation or omission, knowing it to be incorrect, during the lending process with the intention that the lender, borrower or other party to the process rely on it
  • Receiving anything of value by these violations

This particular change may impact the state’s “Mortgage Lending Fraud Prosecution Account,” enacted in 2003. Funded by a $1 surcharge for every deed of trust recorded in Washington state, the account is administered by the DFI for prosecution of criminal fraud in mortgage lending.

According to the DFI, this fund creates more than $800,000 in annual revenue. Expanding criminal penalties into a class-B felony enhances the state’s ability to use these funds.

Decoding the rules

The ideas that borrowers must protect themselves and that “whatever the traffic will bear is permissible” are attitudes of the past in the mortgage industry. Brokers’ affirmative obligation now is to deliver a loan product that the borrower understands and that is prudent for that borrower.

When it comes to litigation, it is no longer enough for mortgage brokers in Washington state to simply produce loan documents that borrowers signed. Instead, they now must greatly increase their communication and show the utmost good faith and fair dealing with clients. This includes ensuring that borrowers understand the loan’s material aspects. Just giving the information is not enough.

Brokers have the affirmative obligation to offer loan products appropriate for borrowers’ risk classification and clearly must avoid excessive loan charges. All communications with consumers -- including advertisements, oral statements and promotional materials -- also must provide clear and balanced information about the products’ benefits and risks.

Brokers also should have timely communication that will help borrowers’ product selection and should not steer them to a particular product to the exclusion of others. Brokers also must explain costs of reduced-documentation loans, as well as risks such as payment shock, prepayment penalties, balloon payments, and lack of escrow for taxes and insurance.

•  •  •

Controls will become especially important and should include written policies and procedures that cover criteria for hiring and training loan personnel; compliance with applicable laws and regulations; consumer disclosures; and record-keeping.

With their new fiduciary duty, brokers must have practices and procedures in place that are well-documented and that include regular reviews.

It also is important to keep any compliance program in writing. Documenting borrower communication also is critical. An undocumented file will be nearly indefensible in light of the new responsibility for brokers to assure that borrowers understand the loan product, its costs and risks and that the product they receive is appropriate to their circumstances.

Though some brokers in Washington and nationwide may balk at these new requirements, it is important to note that ethical business dealings are key to any industry.

Given the mortgage industry’s recent turmoil, ethical behavior is essential for turning its image around. These new bills likely set the stage for doing so.

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