Financial Services Alert - January 11, 2011 January 11, 2011
In This Issue

Massachusetts Supreme Judicial Court Holds That Foreclosing Entities Must Hold Mortgages at Time of Notice and Sale

The Massachusetts Supreme Judicial Court recently held two foreclosures invalid where the plaintiff foreclosing entities had not demonstrated that they were either the record holders of the mortgages or in possession of effective assignments of the mortgages at the time of notice and sale.  In the two cases, written assignments of the mortgages to the plaintiffs (the trustees of securitized mortgage pools) were not executed until 10 and 14 months after the foreclosure sales were consummated, respectively, though one of the assignments purported to have an effective date prior to the date of foreclosure.  After the foreclosures, the plaintiffs separately filed quiet title actions in the Massachusetts Land Court, each seeking a declaration that it held clear title to the properties in question.  The Land Court denied relief, concluding that both foreclosures were invalid because the notices of sale named the plaintiffs as the mortgage holders before they had actually received written assignment of the mortgages in recordable form, in violation of the Massachusetts foreclosure statute’s command that a statutory power of sale may only be exercised by a mortgagee.

On appeal, the Massachusetts Supreme Judicial Court affirmed, holding that the foreclosing entity must hold the mortgage at the time of the notice and sale in order to accurately identify itself as the present holder in the notice of sale and to have the authority to foreclose under the power of sale.  Because the plaintiffs were not the original mortgagees, the Court held that for them to have the authority to exercise the statutory power of sale, they needed to show that they were assignees of the mortgages at the time of the notice of sale and the subsequent foreclosure sale.  Furthermore, because Massachusetts is a “title theory” state, in which a mortgage is viewed as a conveyance of legal title to real estate, the Supreme Judicial Court held that any such assignment must be in written form consistent with the statute of frauds.

In arguing on appeal that they were in possession of valid written assignments of the mortgages in question, plaintiffs relied upon the mortgage securitization documents, claiming that these documents established valid assignments making them the holders of the mortgages before the notice and sale.  The Supreme Judicial Court conceded that an assignment need not be in recordable form at the time of notice and sale, and expressly noted that an agreement assigning a pool of mortgages to a securitized trust can satisfy this requirement if there is evidence clearly and specifically setting forth the chain of title by which the mortgage passed into the pool.  The Supreme Judicial Court concluded, however, that the plaintiffs had failed to provide evidence establishing that the securitization documents actually assigned the mortgages in question.  Both plaintiffs failed to show how the mortgage had been assigned from the originator to the depositors in the pools; the plaintiff in one of the cases failed to offer the pooling and servicing agreement under which the mortgage was assigned into the pool; and the plaintiffs in both cases failed to offer the mortgage loan schedule for either securitization, which identified the specific mortgages being assigned to the pool. In short, although it seems likely that the plaintiffs, in fact, were mortgagees by assignment under the securitization documents, plaintiffs failed to prove as much.  The opinion suggests that if the complete documentation had been submitted, the Court would have ruled in plaintiffs’ favor.

The Court rejected plaintiffs’ separate argument that, because they held the mortgage notes, they had a sufficient financial interest in the mortgages to allow them to foreclose.  Unlike in many states, under Massachusetts law, an assignment of the note does not carry with it an assignment of the mortgage.  As such, the Court ruled, possession of the note does not automatically entail possession of the mortgage.  While the holder of the mortgage holds the mortgage in trust for the note holder, and the note holder has an equitable right to compel assignment of the mortgage to it, the Court held that the note holder may not foreclose unless it is also the holder of the mortgage.

The decision also contained a concurring opinion by two justices which, among other things, stressed that the Court’s decision does not address the rights of a bona fide purchaser of foreclosed property, or any other remedy for that matter.

The implications of the Ibanez decision will vary considerably depending on the facts of each case and upon the securitization documents that form any part of a chain of title on a Massachusetts loan.  Please feel free to contact Boston Goodwin Procter partners Jim McGarry (617-570-1332) or Rich Oetheimer (617-570-1259) if you would like to discuss Ibanez’ implications for your REO portfolio or otherwise.

Click here for U.S. Bank National Ass’n v. Ibanez, No. SJC-10694 (Mass. Jan. 7, 2011).

President Signs Regulated Investment Company (RIC) Modernization Act Updating Tax Treatment of RICs

On December 22, 2010 President Obama signed into law the Regulated Investment Company Modernization Act of 2010 (“RMA”).  The bill updates the tax regime that applies to Regulated Investment Companies (“RICs”), implementing an array of changes that are generally favorable for RICs, including changes designed to accommodate non-calendar-year RICs and RICs in fund-of-funds structures.  Other notable changes include the repeal of the preferential dividend rule for publicly-offered RICs and implementation of savings provisions to make loss of RIC status less likely.  The principal features of the RMA are summarized below. 

Unlimited capital loss carryovers.  Previously, net capital losses for RICs could be carried over only for eight years and were treated as short-term capital losses in each of those years.  The RMA changes this regime going forward, so that net capital losses starting in 2011 are allocated between long-term and short-term capital losses, which may be carried forward without limitation, similar to the rules that apply to individual taxpayers. 

Savings provisions for failures to meet income and asset tests.  To qualify as a RIC, a company is limited in the assets it can hold and the income it may earn.  The RMA implements savings provisions that allow RICs to correct certain failures to satisfy the income and asset tests, thereby avoiding loss of RIC status. 

For de minimis failures to meet the asset test (defined as failures resulting from the ownership of assets not exceeding the lesser of 1% of the RIC’s total assets or $10 million), a RIC will be considered to have met the test if it meets the requirements of the asset test within six months of the last day of the quarter within which the RIC identifies that it failed the test.  For other failures to meet the asset test that are due to reasonable cause and not willful neglect, a RIC may maintain its status by disclosing the assets that caused the failure, correcting the failure within six months, and paying an excise tax equal to the greater of $50,000 or the highest rate of tax specified in Section 11 of the Internal Revenue Code (“IRC”) upon the net income generated by the assets that caused the failure. 

Failure to meet the income test, if due to reasonable cause and not willful neglect, may now be cured by disclosing each item of gross income and paying an effective 100% tax on the amounts of income that caused the failure. 

Modification of rules relating to dividends and other distributions.  The RMA contains nine provisions reforming the rules relating to dividends and distributions.  Many of these rules are designed to accommodate non-calendar-year RICs and fund-of-funds structures.  

  1. An alternative method of correcting for incorrect designations of special dividends (such as capital gain dividends) on Form 1099s has been provided to reduce the likelihood that shareholders will be required to file amended returns.  This is relevant for RICs that are not calendar year taxpayers, since the problem would tend to arise when certain types of income for the post-December 31 portion of their fiscal year, unknown at the time, affected what shareholders were entitled to report for their own calendar year.  In general, if it is possible to correct the designation with modifications to designations of special dividends for the shareholder’s subsequent taxable year, the RMA provides a mechanism for RICs to do so.  This provision also replaces the former designation requirement for capital gain dividends with a reporting requirement, which may be satisfied by Form 1099. 
  2. The RMA allows for certain disallowed deductions associated with tax-exempt income to be taken into account in calculating a RIC’s earnings and profits.  This fixes an inappropriate result that formerly could occur when RICs investing in tax-exempt bonds distributed an amount that economically was a return of capital to shareholders, but under former law would have been classified as a dividend out of earnings and profits. 
  3. The RMA allows more flexibility for fund-of-funds structures to pass through exempt‑interest dividends and foreign tax credits to shareholders.  The requirement that more than 50% of a RIC’s assets be comprised of municipal bonds (in the case of exempt-interest income) or of stock and securities of foreign corporations (in the case of foreign tax credits) was problematic for the top-tier fund in fund-of-funds structures.  The 50% requirement no longer applies to a fund-of-funds that invests 95% of its assets in cash, cash items, and interests in other RICs. 
  4. The RMA allows more flexibility for RICs to make spillback dividends, but limits the time period for making such dividends.  Spillback dividends are those which are declared in a taxable year and used to calculate the dividends-paid deduction for that taxable year, but are not actually paid until the subsequent year.  Previously, RICs were required to pay spillback dividends no later than the payment of the next regular dividend, and within twelve months.  The RMA allows RICs to make spillback dividends with the first payment of the same type of dividend, but also generally limits the time period to nine months and fifteen days. 
  5. The RMA makes it easier for non-calendar-year RICs to distribute all their income and avoid the excise tax without inadvertently making a return-of-capital distribution, which can create confusion for shareholders who then receive amended information returns and cost-basis statements.  Earnings and profits of a RIC are now allocated first to pre‑January 1 distributions, instead of being allocated pro-rata over all the distributions during the RIC’s taxable year. 
  6. The RMA exempts publicly-offered RICs from the requirement that they determine whether a distribution is “essentially equivalent to a dividend,” so that all publicly‑offered RICs with shares redeemable upon demand may automatically treat distributions in redemption of stock as exchanges and not dividends. 
  7. The RMA repeals the preferential dividend rule for publicly-offered RICs, a rule which had, according to Congress, “largely served as an unintended trap for mutual funds that make inadvertent processing or computational errors.”  The IRC no longer will disallow a dividends-paid deduction for preferential dividends.  Securities laws which were passed subsequent to the initial enactment of the preferential dividend rule are now presumed to independently protect investors. 
  8. The RMA allows RICs to defer late-year losses to avoid the need for shareholders of non-calendar-year RICs to receive amended information returns and cost-basis statements.  Under former law, if a RIC suffered certain late-year losses, the RIC’s taxable income, net capital gain, or earnings and profits could have been affected in a way that changed what should have been reported to shareholders.  RICs may now elect to treat certain late-year losses as arising on the first day of the RIC’s next taxable year. 
  9. The RMA exempts shareholders of certain “daily dividend companies” from a rule disallowing losses on the sale or exchange of RIC stock held for six months or less to the extent that the shareholder previously received an exempt-interest dividend.  RICs and their shareholders may escape the application of this rule by declaring dividends on a daily basis in an amount equal to at least 90% of net tax-exempt interest, and distributing such dividends at least monthly. 

Modification of rules related to the RIC excise tax.  The RMA contains three provisions allowing RICs to better avoid the excise tax imposed for failure to distribute sufficient income in a calendar year.  In addition, the RMA increases the required distribution percentage of net capital gain income from 98% to 98.2%. 

  • The RMA extends an excise tax exemption for RICs with tax-exempt shareholders.   Formerly, this exemption applied only to RICs in which all shareholders were 401(a) trusts or segregated accounts underlying variable insurance contracts.  Now, RICs owned by other tax-exempt pension and retirement plans are also exempt from the excise tax. 
  • The RMA expands a rule allowing RICs to treat certain ordinary income derived after October 31 as arising on the first day of the following calendar year, a rule intended to allow RICs some flexibility in determining how much they should distribute to shareholders.  The RMA now allows ordinary gains or losses from the sale, exchange, or other disposition of property, including foreign currency gains or losses, to be similarly deferred. 
  • The RMA accommodates non-calendar-year RICs electing to pay tax on gain from market discount bonds to avoid making a taxable distribution to shareholders.  RICs may make quarterly estimated tax payments, and treat the amount on which tax is paid as distributed for purposes of the excise tax.  Formerly, the deemed distribution was not deemed to occur until the end of the taxable year.  Now, certain quarterly estimated tax payments may be taken into account as they are made to cause the underlying amounts to be deemed as distributed for the purposes of the excise tax. 

Miscellaneous provisions.  The RMA contains two miscellaneous provisions.  First, the RMA aligns the deficiency dividend penalties applying to RICs with the more lenient penalties applying to REITs.  Now, only an interest charge is applied, instead of an interest charge and an additional penalty. 

Finally, the RMA implements a time limitation on the rule that shareholders increase their basis in RIC stock by the amount of a load charge paid with respect to previously owned RIC stock.  This rule was formerly not time-limited, which Congress found to create administrative problems due to its potential application after the passage of many years.  The application of this rule is now limited to RIC stock acquired before January 31 of the calendar year following the disposition of the RIC stock that bore the load charge.  

CFTC Proposes Core Principles for Swap Execution Facilities

The CFTC issued a release proposing rules, guidance and acceptable practices that apply to the registration and operation of new types of entities called swap execution facilities (“SEFs”), which are regulated marketplaces for the trading or processing of swaps that (a) facilitate the execution of swaps and (b) are not designated contract markets.  The proposed rules implement the new statutory framework for SEFs in connection with core principles set forth by, and new regulations under Sections 5h and 2(h)(8) of the Commodity Exchange Act enacted by, the Dodd-Frank Act.  The CFTC is seeking comment on all aspects of the proposed rules, guidance and acceptable practices; comments are due on or before March 8, 2011.

CFTC Proposes Governance Requirements and Regulations Mitigating Conflicts of Interest for Derivatives Clearing Organizations, Designated Contract Markets and Swap Execution Facilities

The CFTC issued a release proposing rules relating to the resolution of conflicts of interest in derivatives clearing organizations (“DCOs”), designated contract markets (“DCMs”) and swap execution facilities. The proposed rules would implement core principles concerning governance fitness standards and the composition of governing bodies for DCOs and DCMs, and would more generally implement new requirements to (i) reporting, (ii) identification and mitigation of conflicts of interest, (iii) transparency of governance arrangements and (iv) limitations on the disclosure or use of non-public information.  The proposal is designed to implement Sections 725(c), 735(b) and 733 of the Dodd-Frank Act and complements an October 2010 CFTC release proposing rules related to both (i) structural governance requirements and (ii) limits on ownership of voting equity and the exercise of voting power that primarily was aimed at implementing sections 725(d) and 726 of the Dodd-Frank Act.  Comments on the proposal are due on or before March 7, 2011.

Consumer Financial Protection Bureau Signs MOU with Conference of State Bank Supervisors

The Consumer Financial Protection Bureau (“CFPB”) entered into a memorandum of understanding (“MOU“) with the Conference of State Bank Supervisors (“CSBS”) whereby the CFPB and CSBS agreed to work cooperatively on oversight of providers of consumer financial products and services such as mortgage loans, private student loans, payday loans and other consumer financial services.  The MOU provides that the CFPB and CSBS will work closely together to: (1) promote consistent examination procedures; (2) coordinate supervisory activities, (3) promote efficient information sharing; (4) enforce federal and state consumer protection laws; and (5) minimize the regulatory burden on providers of consumer financial services and products.  The MOU also states that the CFPB and the CSBS will consult on exchanging information regarding, and/or jointly developing, training programs for examiners concerning the standards, procedures and practices used by the CFPB and CSBS.  The MOU also addresses the need to ensure maintaining the confidentiality of information that is exchanged under the MOU.  It is expected that the focus (at least initially) of the CFPB and CSBS with respect to the MOU will be on non‑depository financial institutions.