The New Jersey Supreme Court’s ruling reaffirms the federal preemption provided by the Parity Act and the 1996 OTS Parity Act Regulation, and should give the financial industry some degree of comfort that if they act consistently with the laws and regulations established by Congress and their expert federal regulators, they cannot be second-guessed in state court for that lawful behavior.
On May 26, 2004, the Supreme Court of New Jersey in Glukowsky v. Equity One, Inc., 2004 WL 1159735, reestablished the ability of state housing creditors to continue to rely on the express federal preemptive authority of the Alternative Mortgage Transaction Parity Act of 1982, 12 U.S.C. §3801 et seq. (the "Parity Act"), which has allowed them to make alternative mortgage loans in thousands of transactions, and to enforce those transactions as written.
New Jersey’s Appellate Division had created a firestorm of uncertainty in the state’s residential mortgage market when, on April 24, 2003, it struck down the 1996 federal Office of Thrift Supervision ("OTS") Parity Act Regulation, 12 C.F.R. §560.220, labeling the regulation arbitrary, capricious, ultra vires and therefore invalid and without preemptive effect. In a 4–3 decision, the New Jersey Supreme Court reversed the state’s Appellate Division and reinstated the trial court’s 2002 dismissal of a putative class action complaint alleging that the defendant housing creditor had charged a prepayment fee in connection with a 15-year fixed-rate home mortgage balloon loan in violation of New Jersey’s prepayment fee prohibition. The Supreme Court’s decision reaffirms the preemptive authority of the Parity Act and the 1996 OTS Parity Act Regulation that allowed the state’s housing creditors to contract for and enforce prepayment fees in alternative mortgage transactions ("AMTs"), notwithstanding any contrary state law. In a broader sense, the decision resolves important questions of federalism and separation of powers.
Equity One is a state-chartered residential housing creditor. In October 1999, Plaintiff Mark Glukowsky financed the purchase of his residence with a balloon loan from Equity One. Glukowsky’s note included a Prepayment Rider obligating him to pay a prepayment fee if he prepaid the loan in full during the first three years of the loan term. After paying off his loan (including the contractually agreed-upon prepayment fee) less than 18 months after closing, Glukowsky sued Equity One, claiming that New Jersey’s Prepayment Law, N.J.S.A. 46:10B-1 et seq., prohibits collection of a prepayment fee on a residential mortgage. Equity One moved to dismiss the Complaint, arguing that Plaintiff’s claims are expressly preempted by the Parity Act and the 1996 OTS Parity Act Regulation.
The Parity Act was enacted in the context of a tight credit market, in response to "increasingly volatile and dynamic changes in interest rates," which had strained the ability of housing creditors to provide traditional mortgage financing. In the Parity Act, Congress acknowledged that each of the three federal regulators (the Office of the Comptroller of the Currency ("OCC"), National Credit Union Administration ("NCUA") and the Federal Home Loan Bank Board ("FHLBB")—predecessor to the OTS) had adopted regulations authorizing federally chartered institutions to engage in AMTs. The Parity Act defines AMT very broadly to include a wide variety of instruments, such as adjustable rate and balloon mortgages, that do not conform to the traditional fixed-rate, fixed-term mortgage transaction. The express purpose of the Parity Act is "to eliminate the discriminatory impact that those regulations have upon nonfederally chartered housing creditors and provide them with parity" by authorizing all housing creditors to make, purchase, and enforce AMTs so long as the transactions are in conformity with the federal agency regulations governing AMTs. 12 U.S.C. §§3801(b), 3803(a).
The Parity Act authorizes federally and nonfederally chartered housing creditors alike to engage in AMT lending, "notwithstanding any State constitution, law, or regulation." 12 U.S.C. §3803(c). In effect, it creates a federal AMT program, which nonfederally chartered housing creditors may follow as an alternative to state law in offering AMTs. The Parity Act preempts state law to the extent necessary to allow nonfederally chartered housing creditors to engage in AMT lending on the same terms as federal housing creditors.
When it enacted the Parity Act, Congress directed the federal agencies to "identify, describe, and publish those provisions of their respective regulations that are inappropriate for (and thus inapplicable to), or that need to be conformed for the use of, the nonfederally chartered housing creditors…" OTS responded directly, specifically and in a limited way with the 1996 OTS Parity Act Regulation, which identified three OTS regulations as appropriate and applicable to AMTs: 12 C.F.R. §560.33 (regarding late charges), 12 C.F.R. §560.34 (regarding prepayment fees), and 12 C.F.R. §560.35 (regarding variable interest rate disclosures). 12 C.F.R. §560.34 expressly authorizes prepayment fees ("…subject to the terms of the loan contract, a federal savings and loan association may impose a fee for prepayment of a loan.").
In its decision, the Appellate Division placed great emphasis on what it described as "significant, albeit unusual" developments in the regulatory landscape during the pendancy of the appeal. Specifically, on April 25, 2002, the OTS published a Notice of Proposed Rulemaking, inviting comment on proposed revisions to the 1996 OTS Parity Act Regulation. Alternative Mortg. Transaction Parity Act; Preemption, 67 Fed. Reg. 20,468 (Apr. 25, 2002). That notice announced that OTS was considering removing its regulation permitting the assessment of contractual prepayment fees from its list of regulations "applicable" to AMTs. After voluminous response during the comment period, OTS issued a Final Rulemaking on September 26, 2002. That rulemaking indicated that, from the effective date of the rule change forward, its prepayment fee regulation would no longer be included among its list of regulations applicable to AMTs. Alternative Mortg. Transaction Parity Act; Preemption, 67 Fed. Reg. 60,542 (Sept. 26, 2002). The Revised OTS Parity Act Regulation was originally scheduled to take effect on January 1, 2003, but on December 12, 2002 OTS announced it would delay that date by six months, until July 1, 2003, to allow regulated entities sufficient time to prepare for compliance with the revised regulation. Alternative Mortg. Transaction Parity Act; Preemption Delay of Effective Date, 67 Fed. Reg. 76,304 (Dec. 12, 2002).
The Appellate Division read OTS’s Supplemental Information to the Proposed Rulemaking as a "repudiation" of the 1996 OTS Parity Act Regulation. Largely on that basis, the Appellate Division declared the regulation to be invalid and without preemptive effect. The decision declared that the OTS’s own interpretation of the Parity Act, as well as the interpretation expressed by the United States District Court for the District of New Jersey in Shinn v. Encore Mortg. Svcs., 96 F. Supp. 2d 419 (D. N.J. 2000) and the Fourth Circuit Court of Appeals in Nat’l Home Equity Mortg. Ass’n v. Face, 239 F. 3d 633 (4th Cir.), cert. denied, 122 S. Ct. 58 (2001) were "incorrectly decided." The Appellate Division expressly declined to rule, however, on whether its decision should be applied retroactively or only prospectively; it remanded the case to the Law Division for further proceedings before the trial court on that issue.
Equity One petitioned New Jersey’s Supreme Court to review the Appellate Division’s decision and on September 17, 2003, the New Jersey Supreme Court granted Certification. The Court also granted leave for several mortgage industry and consumer groups to appear as amicus curaie: Mortgage Bankers Association of New Jersey; National Home Equity Mortgage Association; American Bankers Association; American Financial Services Association; America’s Community Bankers; Consumer Bankers Association; Consumer Mortgage Coalition; Mortgage Bankers Association of America; New Jersey Financial Services Association; New Jersey League of Community Bankers; and Legal Services of New Jersey. The Court heard oral argument of the appeal on February 3, 2004.
Amici counsel emphasized to the Court that, in the wake of the Appellate Division decision, each and every payoff of an AMT involving a prepayment fee in New Jersey (whether resulting from a refinancing or a sale of continued on page 14 mortgaged residential property) was suffused with uncertainty as to the legality and enforceability of contractual rights and obligations among borrower, lender, servicer, regulators and secondary market investors. This uncertainty had already touched off a flurry of individual and putative class action litigation threatened and filed on behalf of borrowers contesting prepayment fees.
Contractual prepayment fees are designed to protect the lender against potential losses it may incur if a loan is paid earlier than contractually agreed. Such a prepayment term is usually given in exchange for a lower interest rate to the borrower. A prepayment fee term in a loan influences not only the interest rate charged to the borrower, but also the pricing of the loan on the secondary market. Because the prepayment rate assumption, used to value the loan in the secondary market, is significantly discounted when a prepayment penalty is in- cluded in the mortgage contract, a loan with a prepayment fee term is more valuable, will bring a greater return on the secondary market, and, in turn, may be offered by the originator to the consumer at a lower price. Besides affecting secondary market loan pricing, prepayment fee provisions are implicated in the seller representations typically contained in bulk loan purchase agreements. For example, a seller typically makes representations as to (1) the genuineness of mortgage documentation (including representation that the Note, Mortgage and other documents executed therewith are legal, valid, binding and enforceable in accordance with their terms); and (2) regulatory compliance with the requirements of applicable state, federal or local laws. Such representations typically carry with them indemnification and/or repurchase obligations, if breached. Such indemnification and/or repurchase clauses might have been triggered, resulting in potential claims against loan sellers (and corresponding litigation) if Appellate Division’s invalidation of the existing prepayment fee provision were upheld.
But New Jersey’s Supreme Court disagreed with the Appellate Division’s conclusion that OTS had exceeded its Congressionally delegated authority in issuing its 1996 Parity Act Regulation. Particularly where, as in the Parity Act, Congressional intent is not entirely clear from the language of the statute, the Court emphasized that the interpretation of the agency responsible for enforcing that statute is entitled to "substantial deference." Deference to agency decisions is warranted, the Court reiterated, "because the responsibilities for assessing the wisdom of such policy choices and resolving the struggle between competing views of the public interest" are ones not for the courts, but for expert regulators.
The Court emphasized that the deference owed to an agency decision is no less substantial because an agency might change its mind over the years. "Regulatory law is not static," the Court noted. "It has elasticity that permits it to adapt to changing circumstances and conditions." OTS has done just that in the case of prepayment fees in AMTs: effective July 1, 2003, OTS’s regulations leave to state law regulation of prepayment fee provisions in new AMT loans made by statechartered lenders. But the Court clarified that this change in policy does not alter the validity of OTS’s previous regulation. In other words, state-chartered lenders who contracted for prepayment fees under the authority of OTS’s 1996 Parity Act Regulation may enforce those provisions of their loans.
Additionally, the Court noted that the principle of "comity" instructs state courts to give due regard to a federal court’s interpretation of a federal statute. Federal courts looking at this same issue have consistently concluded that OTS acted within its Congressionally delegated authority in adopting its 1996 Parity Act Regulation allowing state-chartered lenders to impose prepayment fees in AMTs. Although not binding on New Jersey’s courts, the Supreme Court noted these federal decisions are entitled to "respectful consideration in the interests of judicial comity." Such consideration toward the decisions of federal courts helps ensure uniformity and discourage forum shopping.
Finally, the Court noted that this particular case had highlighted for the first time a "gap" in its own rules. New Jersey’s court rules require that a party challenging the validity of a state statute, rule, regulation or executive order give notice of that challenge to the state’s Attorney General. Currently, no comparable rule exists requiring notice to the attorney or chief legal officer of a federal department or agency whose law or regulation is challenged. The Court’s decision submitted to New Jersey’s Civil Rules Practice Committee an appropriate rule revision to require such notice be given when a federal law or regulation is challenged in a New Jersey court.
The New Jersey Supreme Court’s ruling reaffirms the federal preemption provided by the Parity Act and the 1996 OTS Parity Act Regulation, and should give the financial industry some degree of comfort that if they act consistently with the laws and regulations established by Congress and their expert federal regulators, they cannot be second-guessed in state court for that lawful behavior. As Justice Albin noted in a colloquy with amicus counsel at oral argument, a housing creditor ought to be able to take an OTS regulation "to the bank."
This article is presented for informational purposes only and is not intended to constitute legal advice.
