February 2014 Legal Briefs

• Lessons from the Chase ‘Madoff penalties’
• FDIC tech assistance video series
• Bureau is looking for mortgage ‘pain points’
• Revised consumer booklets
• Still handling paper items?
• Cross-Collateralization
• Garnishments — When all funds are protected
• Record retention — Part 1

Lessons from the Chase ‘Madoff penalties’

By John S. Burnett

JPMorgan Chase banks are no strangers to the headlines, and their names have appeared several times in reports of regulatory enforcement actions. It’s become easy to assume that any news article featuring one of the JPM Chase banks will be a report of yet another enforcement action or court settlement. Last month’s announcements by FinCEN, the OCC and the U.S. Attorney’s Office for the Southern District of New York (SDNY) were no exception.

But we miss an opportunity when we read such news and simply think, “There they go, again.” Instead, we can dig into the nuts and bolts of such announcements to glean insight into what went wrong, and what lessons we can find in the actions of the bank and those of regulators and law enforcement.

The JPM Chase banks have been chastened before for alleged shortcomings in their BSA compliance programs. Just over a year ago, the Federal Reserve Board and the OCC issued consent enforcement orders against JPMorgan Chase & Co. and each of its national bank subsidiaries requiring improvements in their firmwide BSA/AML compliance program.

Based on the January 7, 2014, orders from FinCEN and the OCC and the press release concerning the Deferred Prosecution Agreement with SDNY, last month’s actions against JPMorgan Chase Bank, N.A. are all about the bank’s actions — lack of action is probably a better phrase — relating to the infamous multi-billion dollar Ponzi scheme operated by Bernard Madoff. FBI Assistant Director-in-Charge George Venizelos, quoted in the SDNY’s press release, said “J.P. Morgan failed to carry out its legal obligations while Bernard Madoff built his massive house of cards. Today, J.P. Morgan finds itself criminally charged as a consequence. But it took until after the arrest of Madoff … for J.P. Morgan to alert authorities to what the world already knew. In order to avoid these types of disasters in the future – we all need to be invested in making our markets safer and more equitable. The FBI can’t do it alone. Traders, compliance officers, analysts, bankers, and executives are the gatekeepers of the financial industry. We need their help protecting our markets.”

In the early 1990s the bank learned that Madoff and a client of JPMorgan’s Private Bank were engages in what appeared to be “round-tripping” check kiting transactions. Another bank involved in those transactions (Madoff Bank 2) recognized them as suspicious, and in the mid-1990s filed a SAR and shut down the account, which Madoff moved to JP Morgan, and the size of the suspect transactions got larger. In 2001, they were about $6.8 billion in such circular transfers in a series of $90 million transfers.

On 2006, a derivative trading desk at the London branch of JPMorgan’s Investment Bank took notice of Madoff. That bank started issuing billions of dollars in Madoff-linked securities. By October 2008, a due diligence team at the Investment Bank circulated a negative memo about ongoing concerns about Madoff, and suggested that “JP Morgan ‘seem[ed] to be relying on Madoff’s integrity’ with little reason to do so.”

JP Morgan’s London branch filed a report with UK regulators about its concerns concerning Madoff, but the U.S. bank never took that step with FinCEN or other U.S. law enforcement officials, partly because its anti-money laundering compliance officers never followed up on information supplied by the UK office. In the meantime, as Madoff’s December 2008 arrest loomed, Madoff accounts at JPMorgan were being drained as worried investors started redeeming their Madoff Funds investments.

The FinCEN order clearly indicates that JPMorgan Chase Bank’s failure to detect and adequately report the Madoff suspicious activity is the basis for both its and the OCC’s CMP Orders, and for the criminal complaint by the SDNY. The SDNY announcement argues convincingly that, if the bank had filed timely SARs on the Madoff transactions, law enforcement would likely have been able to take action much sooner than the fall of 2008 to shut down the Madoff scams, thus limiting not only the huge amounts of money sucked up into the Madoff machine, but also the large numbers of victims whose life savings were wiped out.

The can be no doubt after reviewing this and similar cases that law enforcement and regulators are increasingly taking the view that protection of the public from frauds like the Madoff schemes is part of the duty of financial institutions who are in a position to detect suspicious activity and file timely SARs.

One aspect of this case — the failure of one arm of the bank to react appropriately to information known by another bank unit (the London Investment Bank) — is not a new concern for banks. Ten years ago, one of the key factors in the decision to hit AmSouth Bank (merged into Regions Bank in 2006) with a $10 million CMP was a lack of internal controls and procedures to integrate information from numerous bank units to enable compliance with BSA requirements, such as reports suspected fraud being conducted through accounts at the bank.

The key lessons, then, are to take an enterprise-wide view of BSA/AML compliance, whether you’re a one-office bank or one with scores of branches and departments, and to ensure that all personnel have bought into a compliance culture that will ensure that scams and other frauds get reported.

FDIC tech assistance videos series

By John S. Burnett

An FDIC announcement in early January caught our eye. It touted the agency’s release of four new technical assistance videos. There are now seven topics in the series, offering technical training to bankers on a range of regulatory issues – from the perspective of the FDIC. We hadn’t seen the FDIC mention this series in a while, so we are offering this reminder that it is available, on the FDIC website. From the agency’s home page, click to “Regulations and Examinations,” then to “Resources” and the “Directors’ Resource Center.”

Each of the topic areas includes a series of videos. Currently, the topic areas in the series include:

• Allowance for Loan and Lease Losses (ALLL)
• Appraisals and Evaluations
• Evaluation of Municipal Securities
• Flood Insurance
• Interest Rate Risk
• Managing Fair Lending Risk
• Troubled Debt Restructuring (TDR)

Bureau is looking for mortgage ‘pain points’

By John S. Burnett

On January 3, the Consumer Financial Protection Bureau published a Federal Register notice asking for information on key consumer “pain points” associated with mortgage loan closing, and how those problems might be addressed by market innovations and technology. With that notice, the Bureau marks the beginning of the next phase of its “Know Before You Owe” initiative, which will look for ways to improve the mortgage closing process.

The announcement reminded us of the Bureau’s November 20 Boston Field Hearing, during which the Final Rule on its “Now Before You Owe” integrated RESPA/TILA pre-closing disclosure forms. We were fortunate to attend that meeting, and we took special note at the time of a comment offered by a panel participant that the new three-days-before-consummation delivery schedule for final combined RESPA/TILA mortgage closing disclosures would bring pressure on industry participants – the panelist was from a large title company – to reinvent the loan closing process, perhaps in a less paper-intensive, more electronic, form. We remember thinking at the time that it would take the equivalent of moving mountains to get that accomplished by August 2015, when the new disclosure forms will be required, just to plow through the overwhelming collection of paperwork that has accreted over the years, each new form designed to address some real or perceived problem, and decide what needs to stay, and what can go, and how to provide the necessary information that remains.

Apparently one significant player in the marketplace has decided to take the electronic plunge. HUD recently announced that FHA policy will allow for e-Signatures on origination, servicing, and loss mitigation documents, along with FHA insurance claims, REO sales contracts and related materials.

Could it be that we are about to experience an upheaval in the loan closing process? We can well imagine that within the next two or three years, loan closings will be very different from those we are experiencing now! It almost makes me want to take out another mortgage in 2016, just to see what’s changed by then.

But then I come to my senses.

Revised consumer booklets

By John S. Burnett

If your bank is running low on any of the three consumer information booklets that are supposed to be handed out in connection with mortgage applications – What You Should Know about Home Equity Lines of Credit for HELOC applications; the “CHARM” booklet for adjustable rate mortgage applications; and Shopping for Your Home Loan (the Settlement Cost Booklet) – don’t forget that the Bureau has just announced the availability of updated versions of each of them.

You can use up any supplies of the current versions of those booklets that you have, but be sure you get the new version when you reprint or order a new supply.

Still handling paper items?

By John S. Burnett

If your bank is still sending some paper items – checks, savings bonds, Canadian items, Treasury items, postal money orders, foreign items and paper adjustments, etc., to the Atlanta Fed, be aware that you should be using a new address.

Federal Reserve Financial Services has announced that beginning February 4, all paper items being sent to the Atlanta Fed via mail, courier or overnight service, should be addressed to the:

Federal Reserve Bank of Atlanta
Attention: Check Operations
1000 Peachtree Street, NE
Atlanta, GA 30309-4470

Cross-Collateralization

By Pauli D. Loeffler

The May 2000 Legal Briefs contained Charles Cheatham’s article entitled “Future Lending Secured by Earlier Filings” covering the nature and extent of the security interest a bank has under a previously filed mortgage, UCC-1 or lien entry on a certificate of title when the note has been paid down, and the bank wants to “lend back up” (advance new money) in some amount not exceeding the original indebtedness. The conclusion stated in the May 2000 article is:

In summary, there is no “short-cut” that a bank can use to “loan back up” to the bank’s previous dollar amount of secured position without being required to check intervening filings or make new filings. And the “mandatory future advance” approach, which can be helpful in the commercial lending context, is likely to be too complicated to be useful in the consumer context, except for home equity lines of credit, where the attractiveness of the product and the quantity of loans generated may justify the greater complexity of dealing with special forms and disclosures.

[Legal Briefs articles prior to January 2005 are no longer available online. Contact Pauli Loeffler for a copy.]

The May 2000 article did NOT address future advances clauses nor existing indebtedness when revolving lines of credit (commercial and HELOC) were not involved, nor directly address cross-collateralization clauses (also known as “dragnet clauses” and “spreader clauses”). Because I hate typing, am lazy and every letter is another key stroke, I will be using “dragnet clause” in this article.

Dragnet clauses are typically used in commercial financing, and do show up in consumer loans even though these generally are a nullified due to the plethora of issues involved. Here is an example of an all-encompassing dragnet clause found in a commercial mortgage or security agreement that would cover both existing indebtedness and future advances:

All future loans and advances and all future renewals of loans which Mortgagee may make to Mortgagor or to the Debtor identified in the Note, if different from Mortgagor (the “Debtor”); and all other debts, obligations and liabilities of every kind and character of Mortgagor or Debtor now existing, whether or not explicitly referred to, or arising in the future in favor of Mortgagee, whether direct or indirect, absolute or contingent, or originally payable to Mortgagee or any other person; and any renewals or extensions; provided, however, if the Mortgaged Property includes Mortgagor’s principal dwelling or is otherwise a 1 to 4 family dwelling, the Mortgaged Property will not secure any future loan, advance, debt, obligation or liability taken or incurred principally for a personal, family or household purpose. [Emphasis added]

The italicized provisions require the mortgage for the loan containing this clause specifically include the legal description of the principal dwell or any 1 to 4 family dwelling in order to secure any pre-existing indebtedness. Note that any future loan or other indebtedness that is consumer purpose (e.g., overdrawn personal account or a car loan) will not be subject to the dragnet clause. The reasons for the exclusions will be made clear below.

A dragnet clause in an unsecured loan is ineffective! No matter how inclusive the clause may be, if there is NO collateral for the loan, there is nothing it can “drag” in as security. The bank cannot add charged off amounts from another loan or an account to the unsecured loan. Of course, a line of credit for overdrafts would allow adding overdrafts up to the limit of the line of credit as long as it is open-ended.

A dragnet clause between bank and borrower must clearly, unambiguously and unequivocally indicate the intention of the parties that existing indebtedness and/or future advances are covered. Dragnet clauses are generally disfavored. If doubt exists regarding the parties’ intent to include a prior debt or a future advance, such debt will NOT be secured by the collateral. As pointed out in the May 2000 article, a clause in a mortgage for advances to cover covenanted items provided by the mortgage/security agreement such as insurance, taxes, and maintain the value of the collateral is not the same as a mandatory future advances clause, and with the exception of the covenants, the lender cannot “lend back up” and maintain a security interest with the same priority. Even with a dragnet clause, the lender may be faced with the issue of whether a prior debt has been merged into a new obligation or otherwise paid in full affecting the extent and priority of security interest depending on the factual situation.

A dragnet clause in a secured consumer loan, even if clear, unambiguous and unequivocally indicating the parties’ intent to secure existing debts and/or future advances, with the exceptions of an open-end HELOC, generally are ineffective (or less than useful). Besides the right of rescission problem, a closed-end mortgage containing a dragnet clause secured by the consumer’s principal residence or real estate presents the lender with a multitude of disclosure issues under Reg Z’s Sec. 1026.18(m) (“spreader clauses”) and Sec. 1026.18(s) as well as possible violations of Reg AA’s Sec. 227.13 (no, Reg AA has NOT been repealed). [Reg AA was repealed March 21, 2016, but the short answer as expressed by the regulators is that financial institutions should continue to follow the rules that were contained within the regulation.] The lender will also risk nullification of the dragnet clause under Sec. 1026.19 (early Truth-in-Lending disclosure requirements), Sec. 1026.32 (High Cost Mortgages), Sec. 1026.35 (HPML) and Sec. 1026.43 (QMs). Timing requirements for delinquency notices such as the HUD SCRA as well as Reg X’s Sec. 1041(f)(i) prohibition against foreclosure referral until the borrower is more than 120 days delinquent on the mortgage would defeat a dragnet clause in the mortgage when the borrower is current on the mortgage but is in default on another debt.

A dragnet clause may be “less than useful” when the collateral is secured by personal property of declining value. A dragnet clause in a financing statement secured by personal property, such as an automobile, a recreational vehicle, or a boat may not provide the lender much additional security due to the declining value of the collateral.

Garnishments – When All Funds Are Protected

By Pauli D. Loeffler

I wrote about the final Garnishment of Federal Benefits Rule (effective June 28, 2013) in the June 2012 Legal Briefs commenting on the changes that were made from the interim rule. One of the changes was an addition to Sec. 212.7 regarding the Notice to Account Holder. The interim rule required sending the notice if protected federal benefits are directly deposited into an account (the rule does not apply to paper checks or amounts transferred to another account), and the account balance is greater than $0. The final rule added additional language that the notice is required if the account analysis for the look-back period reveals unprotected funds. I previously noted that if all funds in the account receiving direct deposit are protected, it is unnecessary to send the Notice to Account Holder for accounts not subject to rule whether the source of those funds were federal benefits transferred from another account or otherwise. Neither the federal rule nor Oklahoma law requires the bank to claim the exemption.

The rationale behind adding the new language was that sending a notice to account holders in cases where all funds in the account receiving direct deposit were protected would be of little benefit and would likely result in unnecessary confusion. Unfortunately, this change may actually cause confusion under Oklahoma’s garnishment statue.

The problem is caused by two Oklahoma statutes. Title 12 O.S. Sec. 1172.2 provides:

A. When a garnishment summons is issued in any action after the judgment is filed, the court clerk shall attach to the garnishment summons a notice of garnishment and exemptions required by subsection C of Section 1174 of this title and an application for the defendant to request a hearing. If the garnishee is indebted to or holds property or money belonging to the defendant, the garnishee shall immediately mail by first-class mail a copy of the notice of garnishment and exemptions and the application for hearing to the defendant at the last-known address of the defendant shown on the records of the garnishee at the time the garnishment summons was served on the garnishee.

Additionally, Title 12 O.S. Sec. 1178.2 which covers the Garnishee’s answer states:

A. Where the garnishment summons is not on earnings, is not for the collection of child support and is issued under Section 1173.3 of this title, then…the garnishee shall, within ten (10) days from the service of the garnishee’s summons, file an affidavit with the clerk of the court in which the action is pending and deliver or mail a copy thereof to the judgment creditor’s attorney or to the judgment creditor if there is no attorney. The affidavit shall state:

1. Whether the garnishee was indebted or under any liability to the defendant named in the notice in any manner or upon any account specifying if indebted or liable, the amount…

5. If the garnishee shall disclose any indebtedness or the possession of any property to which the defendant or any other person makes claim, at the garnishee’s option, the names and addresses of such other claimants and, so far as known, the nature of the claims; and

6. That the garnishee has mailed or hand-delivered a copy of the notice of garnishment and exemptions, application for hearing, and the manner and date of compliance.

The result is that if the bank has ANY funds or a safe deposit box owned by the customer named as judgment debtor whether the funds are protected or not, the bank MUST answer the garnishment indicating it has sent the notice of garnishment and exemptions and application for hearing to the customer. If the customer has NO safe deposit box and the ALL funds on deposit are protected pursuant to the federal rule, the customer may needlessly call the bank or file for a hearing when none is needed. As a courtesy, the bank may wish to advise the customer that no funds have been frozen or remitted by adding a letter with the garnishment packet required to be sent under the Oklahoma statutes. I would designate this as a “Courtesy Notice.” If more than one account receiving protected benefits was involved, you will need to provide information for each account.

In conducting the account review on (date) required under 31 CFR Part 212 (Garnishment of Accounts Containing Federal Benefit Payments), one or more Federal benefit payments were identified as direct deposits into account #________ during the 2 months preceding the date of review. The balance in account # ________ was equal to or less than the direct deposits of federal benefit payments during the 2 months preceding the review, and no funds were frozen or remitted from account #________.

If ANY funds were remitted from an account, this courtesy notice should not be used.

Record retention – Part 1

By Andy Zavoina

If you don’t need it and aren’t legally required to keep it, get rid of it!!!

We spoke to a banker this week who had received a subpoena for 13 years worth of a customer’s DDA records. Was the bank required to keep those records that long? No, but it had not purged the ones that were over 7 years old. Since it had them, it had to either produce them pursuant to a subpoena or successfully file a motion to quash on the basis the subpoena was overbroad or unduly burdensome. It was a perfect example of why the other side of retention – the purging part, is so important.

“How long do we have to retain this (_you fill in the blank_) document?” That is a question we hear a lot. Once upon a time it was simple to answer. You just went to the pages and pages of detailed information based on what the State Banking Board rules required and retention questions could be answered generally from one place. But “once upon a time” ended in 2008 when most of the Oklahoma Banking Board rule section 85:10-3-18 was struck through and replaced with this: “When any law of the state of Oklahoma or federal law requires the retention of a specific record or a specific class, type or category of records for a certain period of time, a bank and trust company shall retain its records falling within such class, type or category for the time period required by such law. If no Oklahoma state law or federal law prescribes a retention period for a specific record or a specific class, type or category of records, a bank or trust company must retain such records for the period of time that would be necessary to prosecute or defend an action for which such records would be required in the prosecution or defense of the action.”

So what this says is, retain applicable documents for a period of time specified in the applicable law or regulation, be it state or federal, and if no such retention rule exists retain the documents for as long as you may have to go to court over it – that is “prosecute or defend” your actions. This is bittersweet as your bank doesn’t have a second set of requirements to follow, plus there will not be any conflicts with this rule, but it also means that when you hear that question of retention, you need to first determine which law or regulation is applicable and then research the retention requirements there. If it isn’t addressed then you must retain the documents for as long as you may need to use them in an action to prosecute or defend what was done.

So what are those retention periods? That is the point of this article. Bookmark it, print it, laminate it as a quick reference – we hope we can answer the majority of your common retention questions right here in a brief description by regulatory requirement. You can attach your own addendum with your specific document listing if desired. Consider this a first installment on this subject. In the future, we’ll augment it with some of the state law provisions (such as those in the Uniform Commercial Code).

The citations below are to relevant sections of the CFPB rules. To see precisely what each one of these record retention periods pertain to, go to the regulation itself.

Regulation and retention period

Reg B – 1002.12 For 25 months (12 months for business credit, except for business that had gross revenues in excess of $1 million in its preceding fiscal year) after the date that a creditor notifies an applicant of action taken on an application or of incompleteness

Reg C – 1003.5 “Retention” is less correct than the availability of data. A “modified” Loan Application Register shall be available to the public for a period of three years and its FFIEC disclosure statement available for a period of five years.

Reg E – 1005.13 Retain evidence of compliance with the requirements imposed by the Act and this part for a period of not less than two years from the date disclosures are required to be made or action is required to be taken

Reg N – 1014.5 The CFPB transitioned this rule from the Federal Trade Commission. It is “Mortgage Acts and Practices—Advertising” and requires retention for a period 24 months from the last date the written or oral statement was made or disseminated the applicable commercial communication (advertisement) regarding any term of any mortgage credit product.

Reg P – 1016.9 An ongoing retention requirement applies to disclosures to customer and indicates the bank must provide the initial notice, the annual notice, and the revised notice so that the customer can retain them or obtain them later in writing or, if the customer agrees, electronically.

Reg V – 1022 App E, III, (c) Maintain records for a reasonable period of time, not less than any applicable recordkeeping requirement, in order to substantiate the accuracy of any information about consumers it furnishes that is subject to a direct dispute.

Reg X – 1024.10 Retain each completed HUD–1 or HUD–1A and related documents for five years after settlement, unless the lender disposes of its interest in the mortgage and does not service the mortgage. In that case, the lender shall provide its copy of the HUD–1 or HUD–1A to the owner or servicer of the mortgage as a part of the transfer of the loan file.

Reg Z – 1026.25 A creditor shall retain evidence of compliance other than for mortgage loans for two years after the date disclosures are required to be made or action is required to be taken.
For loans secured by a dwelling andfor loan originator compensation rules, maintain all records sufficient to evidence all compensation paid to a loan originator and the compensation agreement that governs those payments for three years after the date of payment.

For mortgage loans, effective August 1, 2015 loans secured by real property will be retained for three years.
Reg DD – 1030.9 Retain evidence of compliance with this part for a minimum of two years after the date disclosures are required to be made or action is required to be taken.

Garnishment orders – 31 CFR 212 Maintain records of account activity and actions taken in response to a garnishment order, sufficient to demonstrate compliance with this part, for a period of not less than two years from the date on which the financial institution receives the garnishment order.

Bank Secrecy Act – App P The BSA establishes recordkeeping requirements related to various types of records including: customer accounts (e.g., loan, deposit, or trust), BSA filing requirements, and records that document a bank’s compliance with the BSA. In general, the BSA requires that a bank maintain most records for at least five years.