In no other context in recent memory do we encounter a product market characterized by falling prices and expanded opportunity for entry by first-time consumers, and yet label such market a "crisis." The distinction is that in subprime, we are not dealing with just any other product. At issue is the bedrock of the American dream--home ownership. The reality of the subprime environment is that over the next several years, as adjustable or "teaser" rates reset, many subprime borrowers will be at substantial risk of default. Such mass foreclosures, in addition to the social costs of displaced families, will pose significant risk of loan losses at lending institutions.

The turmoil in the subprime lending market has drawn the attention of Congress, regulators, consumer groups, market analysts, and the average home owner. As the market declined, the perception that subprime loans are akin to predatory loans grew. The remarkable growth in the subprime market in the last 10 years is primarily the result of two distinct factors: investors' continuing search for higher yields and ordinary Americans' pursuit of the American dream of home ownership--at whatever the cost or terms. Subprime loans grew rapidly in the late stages of the housing boom due to strong demand among households that were unable to acquire property in the housing market through traditional financing.

Over the last year, members of Congress, as well as state lawmakers, have introduced a variety of legislative proposals designed to address the problems faced by subprime borrowers, from increased funding for housing counseling and consumer education, to empowering bankruptcy judges to unilaterally change the terms and conditions of an existing mortgage loan to bail out distressed borrowers who made poor borrowing decisions. Federal and state regulators and attorneys general are following suit with guidance/restrictions on subprime lending and handling problem borrowers, and increased supervisory oversight over lenders and their vendors. There has also been an increase in litigation related to the subprime lending market based on discriminatory/predatory lending, an increased call for "suitability standards" in mortgage lending, and nonconsumer lawsuits, such as investors suing issuers, lenders suing brokers, and shareholders/investors suing lenders.

The reality of the continuing subprime fallout given the variation of legislative, regulatory, and market developments, is that those in the lending industry are left to deal with an atmosphere of uncertainty and potentially adverse changes. Current legislative proposals present the risk of changed circumstances, altered expectations, and possible shifts in valuation of mortgage pools. Federal bankruptcy bills currently pending have the potential to be disruptive and costly to the industry since they could result in an avalanche of new bankruptcy filings by borrowers attempting to recast their subprime mortgages. With the possibility of legislative changes, lenders, securitizers, and servicers should expect to see increases in regulatory enforcement activity, by both federal and state regulators, and a rise in litigation by private litigants. The rise in subprime litigation will generally focus on the way that loans are presented to the public and the suitability of loan terms.

Criticism of the way that loans are presented to consumers will focus on (1) the advertising of loans (misleading statements in marketing of subprime products); and (2) the disclosures provided--both specific statutory disclosures, and whether the disclosures are effective in view of the overall nature of the product (i.e., that the product is inherently unfair or deceptive regardless of the amount of disclosure). One of the most widely utilized and versatile weapons for class action plaintiffs' attorneys are state unfair and deceptive acts or practices statutes, commonly referred to as "UDAP" laws, one of the most ubiquitous being California's Unfair Competition Law, Cal. Civ. Code § 17200. Plaintiffs may allege that a lender's practices are immoral, unethical, oppressive, or unscrupulous, and offensive to public policy--generally, an "unfair" practice. Plaintiffs may also argue that the terms of a given loan are deceptive or confusing to an average consumer, such as offering very-short-term "teaser" rates, advertising that rates "may" increase when in fact they undoubtedly will, or providing exotic ARMs that are too complex for the borrower to comprehend--generally, a "deceptive" practice.

Although defense strategies vary based on the facts of the case, certain recurring critical themes resonate: (1) borrowers knew what they were getting at the time and liked the loans; (2) the terms that look bad now were welcomed before; and (3) the borrower's default was actually due to reasons unrelated to the terms of the loan, such as divorce or layoffs. In defending class action claims, most claims are borrower specific, and therefore lenders can defend arguing that the suits lack the commonality required for class certification. Nonetheless, some risk still remains, namely, that class suits are about systemic policies of a lender as applied to all borrowers and not specific circumstances unique to any one borrower.

Suitability

Plaintiffs' attorneys have also attempted to develop a suitability standard for suits against subprime lenders. Most advocates of a new suitability standard for the mortgage lending industry point to the securities industry as a model, likening subprime lending to boiler-room practices. The Securities and Exchange Commission (SEC) has applied the suitability doctrine to boiler-room sales of penny stocks when brokers recommend stocks without obtaining information on their customers' financial circumstances or risk preferences. Boiler-room operations refer to high-pressure sales of low-cost, speculative securities through cold-calls over the telephone to unfamiliar and unsophisticated customers. For example, in Mac Robbins & Co., Exchange Act Release No. 6846, [1961-1964 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 76,853, at 81,174 (July 11, 1962), the SEC held that it is fraud for a broker-dealer "to induce a hasty decision by the customer" where "no effort [was] made by the salesman . . . to determine whether the security recommended [was] suitable for the customer."

Notwithstanding the appeal of having a well-developed body of precedent to serve as a model for applying a suitability standard to the subprime market, suitability is an inappropriate approach for the lending market. Unlike the securities context, where a broker assumes the role of an agent and thus has a fiduciary duty to act in the client's best interest, lenders are not agents of the borrower; rather they are the counterparty to the borrower, acting in their own best interests. Attempting to impose a suitability standard on lenders would alter the fundamental nature of the relationship. In addition to this basic difference in roles, the allocation of financial risk in the two types of transactions further illustrates this critical difference: in making an investment, it is the investor who is taking the market risk; in making a loan, it is the lender who takes the credit risk. Arguably, there are certain risks inherent in the mortgage lending environment, such as foreclosure, credit score/history, and bankruptcy, that militate in favor of a suitability standard. Though these factors are influenced by the conduct of others, such as job loss and the ability to pay one's debts as they become due, the borrower exercises far more control over these variables than the investor in the securities context. Even interest rate fluctuations, or initial teaser rates, are known to the borrower prior to the transaction; thus, the borrower has the ability to avoid the pitfalls of these risks.

Foreclosure Moratoria

While Congress debates a variety of bills that will affect lending to nonprime borrowers in the future, many lawmakers throughout the country at the state and local levels have proposed or have passed a variety of measures to delay foreclosures on subprime loans in the form of moratoria on subprime loan foreclosures. These foreclosure moratoria are either being considered or have already become law in Maryland, Massachusetts, Michigan, Minnesota, New Jersey, and New York. While most current and pending foreclosure moratoria are passed by state legislatures, and the overwhelming majority of which have yet to become law, a recently implemented foreclosure moratorium in Philadelphia, Pennsylvania, provides a notable example of a moderate yet imperfect approach to foreclosure moratoria.

In April 2008, C. Darnell Jones II, President Judge of the Court of Common Pleas of Philadelphia County, announced the creation of the Residential Mortgage Foreclosure Diversion Pilot Program, designed to slow the mortgage foreclosure process. Resisting legislative calls from an outright ban on foreclosures, this program recognizes the economic and legal challenges that a residential mortgage foreclosure sales moratorium would create for lenders and borrowers in Philadelphia. It also affirms that the current housing crisis is caused not just by subprime lending but also by "rising interest rates, unemployment and underemployment." The program applies only to residential owner-occupied properties exposed to judicial sale to enforce a residential mortgage. It prohibits a lender from proceeding to a sheriff sale unless a conciliation conference is held as directed by the program. The conciliation conference, which would be presided over by a case manager or other designated person, would address:

• whether the borrower is represented, and if not, whether a volunteer counsel may be available or appointed;
  
  
• whether the borrower met with a Housing Counseling Agency, as required;
  
  
• whether the Housing Counseling Agency has prepared an assessment or report providing an available loan workout arrangement for the borrower;
  
  
• the borrower's income and expense information;
  
  
• the borrower's employment status;
  
  
• the borrower's qualifications for any of the available workout programs, upon review and application of guidelines established pursuant to the General Court Regulation;
  
  
• assistance with preparation of workout plans and required court orders, as appropriate;
  
  
• the necessity of a subsequent conciliation conference;
  
  
• whether the case may proceed to a sheriff's sale where there is no prospect of an amicable resolution; and
  
  
• any other relevant issue.

The program essentially imposes a mandatory foreclosure mediation requirement that brings together the lender and borrower with the goal of ensuring that the borrower is fully informed of the available options. It also provides borrowers with a mechanism to stay in their homes and avoid foreclosure. At the very least, the program will delay likely inevitable foreclosure evictions.

The Philadelphia foreclosure delay program certainly takes a moderate route toward providing foreclosure relief for subprime borrowers, avoiding some of the negative economic consequences that will likely have resulted from some of the legislatively proposed moratoria being considered elsewhere, such as higher loan costs imposed by lenders to compensate for the possibility of delayed sales (criticized by one Midwestern governor as "legislative risk adjustments") and a scarcity of available mortgage lending entirely.

The Philadelphia program does, however, contain some points of concern for lenders. For example, the program prohibits the sale of foreclosed property "unless a conciliation conference is held," and requires an order to issue memorializing the result of the conciliation conference. However, it does not provide a timeframe to complete case management. Since the program allows the conciliation conference presiding officer (essentially a mortgage social worker) to consider "the necessity of a subsequent conciliation conference" and "any other relevant issue," there is some risk that the formalities of the program may be drawn out unnecessarily. As a more general issue, while the program provides an additional layer of bureaucracy for lenders to navigate in the foreclosure process, lenders always have the option of seeking the court's intervention if they perceive a case manager as needlessly delaying the process.

In the end, the Philadelphia plan likely presents a good balance in answering the call of legislators and consumer groups to provide relief to affected borrowers, while still assuring lenders that the foreclosure process will proceed and that Philadelphia remains a viable market for mortgage lending.

Prosecutors Set Sights on Subprime

Recently, federal and state law enforcement authorities announced that joint task forces in several U.S. cities, including Philadelphia, New York, Los Angeles, Dallas, and Atlanta, will examine possible criminal and regulatory violations related to the subprime lending meltdown. The task forces will determine, among other things, whether lenders and banks securitized fraudulent loans in the creation of subprime mortgage packages, and whether the securitizers of the packaged loans accurately disclosed the risks of the underlying subprime loans supporting the investment bundles.

Federal prosecutors, federal and state law enforcement agencies (including the FBI, postal inspectors, and the HUD inspector general), and regulatory examiners form the task forces. They are investigating mortgage lenders, loan brokers, title companies, real estate developers, and investment banks. Among other issues, prosecutors and regulators are attempting to determine whether the securitizations disclosed that the underlying mortgages were made to some borrowers without proper underwriting documentation, whether lenders approved loans based on inappropriate loan-to-value ratios, and whether lenders and borrowers submitted or knowingly relied on fraudulent appraisals, financial statements, tax returns, and other supporting documents.

The tasks forces also are investigating other potential schemes, such as industry insiders in New York who allegedly sold their personal stakes before the collapse of the hedge funds they managed, individuals in South Florida who allegedly used fraudulent borrower qualifying information to obtain mortgage loans, individuals in Virginia who allegedly fraudulently obtained loans from federally insured institutions through furnishing false documents, and individuals in New York who allegedly received excessive mortgage loans through fraudulent loan applications and settlement statements.

Mortgage lenders, mortgage brokers, title companies, investment banks, real estate developers, and other related businesses must beware of the potentially highly disruptive investigations that are being conducted by prosecutors (the Justice Department, state attorneys general, and local district attorneys) and regulators (Securities and Exchange Commission, Office of the Comptroller of Currency, Federal Reserve Board, U.S. Treasury Department, and state regulators). These investigations could be the result of alleged fraud, insider misconduct, or the actions of third parties.

How federal prosecutors, law enforcement agents, and regulatory examiners come upon suspected misconduct varies. Frequently, a disgruntled employee, attempting to invoke whistleblower status, comes forward with information. In other cases, routine regulatory examinations may uncover irregularities that lead to further investigation. Sometimes a prosecutor, agent, or regulator opens the morning newspaper and decides to take a closer look at a company's activities.

Regardless of how the investigation begins, companies must take a proactive approach to mitigate the risk of intrusive investigations and potential bet-the-company prosecutions. When a prosecutor or regulator launches an investigation, the investigator will typically interview current and former employees, customers, and vendors, generally showing up unannounced at these individuals' homes. However, even before conducting interviews, investigators will use grand jury subpoenas or regulatory civil investigative demands to gather documentary and testimonial evidence, often obtaining this information from third parties and asking those third parties not to disclose the existence of the subpoenas. In cases where the investigation follows more egregious conduct, federal prosecutors may seek wiretaps and use other types of electronic surveillance to obtain evidence. Finally, a company (or its insiders) may be served with search warrants permitting investigators to seize computer hardware and software, as well as other company records.

To help prevent and effectively respond to probes by law enforcement and regulatory authorities, lenders, servicers, and others in the lending process should consider the following tips:

• Implement a Compliance Program.To avoid and/or mitigate allegations of fraud and other misconduct, corporations must implement comprehensive compliance programs designed to detect wrongdoing perpetrated from within and outside of the company and effectively implement remedial measures.
  
  
• Assign Responsibilities. From the board of directors and executives to rank-and-file employees, each member of a company must know what his or her role is in compliance oversight. The tone for implementing and maintaining an effective compliance program must begin with the board of directors, the CEO, and the chief compliance officer. Given the paramount role of compliance in the life of a highly regulated company, the chief compliance officer should not be the general counsel.
  
  
• Know the Rules. You cannot effectively defend your company against an investigation if you wait until a subpoena or search warrant arrives and then learn the rules of the game. Guidance from prosecutorial and regulatory authorities, such as the Justice Department's McNulty Memorandum, the SEC's Seaboard Factors, and the bank regulators' civil money penalty matrix, set forth the government's approach for dealing with corporate targets, addressing a variety of issues, including waiver of privilege, indemnification of officers/employees, consideration of past violations, and the effect of misconduct on third parties. General counsel and chief compliance officers must understand the government's policies before federal agents arrive at the door.
  
  
• Involve Counsel Immediately.As soon as anyone becomes aware of a subpoena relating to the company or interviews of former or current employees, vendors, or customers, immediately notify corporate counsel and retain experienced outside counsel. Counsel can then begin a dialogue with the investigators and attempt to minimize the intrusiveness of the government investigation. Counsel also can begin an internal investigation to assess the risk and collect evidence favorable to the company.
  
  
• Do Not Overreact. Sometimes intrusive government investigations cannot be avoided. Sometimes when the government executes a search warrant, twice as many agents as needed may show up. This is due, at least in part, to the government's goal of overwhelming the target into making admissions of guilt. When informed of a search warrant, notify corporate counsel and retain experienced outside counsel. It also is important that the company's personnel understand their legal rights and responsibilities.
  
  
• Learn the Players. Knowing who is leading the investigation will provide great insight into the goals of the investigation and the remedy that the government is seeking.
  
  
• Document Control. Many regulators have certain rules on document retention (e.g., what must be kept and for how long). Companies should implement comprehensive document retention polices that comply with the regulators' policies and understand how those policies will be affected by a pending government investigation.
  
  
• Internal Compliance Self-Assessments. As part of an organization's internal controls review, periodically review and test the organization's compliance programs. This will serve two purposes. First, it will allow the organization to identify deficits and implement remedial measures to avoid future problems. Second, in the event of future investigations, periodic review and testing will demonstrate to prosecutors and regulators that the organization takes the compliance function seriously.
  
  
• It's Not the Crime; It's the Cover-Up. If there is one thing that corporate and political scandals have shown us, it is that lying about or covering up shortcomings or misconduct only compounds the problem. In the case of lying to federal investigators during the course of an official investigation, it means an indictment for making false statements, which can carry a punishment of five years in prison--even if the lie was not used to cover up a crime. Similarly, based on a post-Arthur Andersen/Enron criminal statute, destroying documents related to an investigation can carry a punishment of 20 years in prison.

Following these recommendations and implementing other proactive mea-sures will help companies avoid the potential adverse legal, financial, and reputational consequences of government investigations.

What to Expect Next

In the aftermath of continuing legislative, litigation, and enforcement developments in the subprime lending industry, we are likely to witness

• tighter underwriting standards,
  
  
• fewer warehouse subprime mortgage lines,
  
  
• fewer subprime lenders,
  
  
• greater self-regulation and reformation, probably driven by the securitization market, to the extent that it continues to exist.

Further, lenders should assume that some measure of litigation may be unavoidable in consumer lending. However they can mitigate the adverse affects and duration of such litigation, as well as regulatory enforcement, through (1) developing sensible document retention policies, including consumer marketing materials; (2) incorporating even nonmandatory regulatory guidance into their policies and procedures; (3) implementing comprehensive employee training programs; and (4) assisting customers in avoiding foreclosure.

Given the social costs to the community, the financial costs to lenders, and the high public criticism that will result from mass foreclosures, lenders are urged to be proactive in working with borrowers to modify loans that are projected to be at risk of default following upcoming rate resets. Last fall, the industry witnessed an overreaction by lawmakers anxious to be perceived as being on the side of subprime borrowers facing foreclosure. Fortunately, in most instances, the deliberative process managed to yield more moderate legislative and regulatory outcomes. Without the subprime lending industry taking the initiative now to avoid a mass of subprime foreclosures in the coming years, the political forces at work in Washington, D.C., and in the states may yield another overreaction that may have unfavorable consequences for lenders.

The increased pressure from the government and consumer groups, combined with new subprime lending standards, will have an effect on lenders' willingness to lend to nonprime borrowers, and investors' willingness to participate in subprime loan securitizations, which over the last few years has been critical to the availability of subprime lending. The result has been and will continue to be a credit crunch for subprime borrowers.

This raises an important public policy consideration that legislators are just beginning to consider and consumer groups are reluctant to acknowledge. The increased clamoring for reforms to the subprime lending industry, on the theory that the existing environment is harmful to a certain portion of consumers, will have the unintended consequence of making it harder for subprime borrowers to achieve the American dream of home ownership. In the end, subprime candidates may have more information, a more open process, and a purportedly more suitable product. However, it may be a product that the majority of candidates may not be able to access.