In December 2012, the Iowa Supreme Court issued a controversial ruling in a sex discrimination case brought under Iowa law. In Nelson v. Knight, the court held 7–0 that a male employer may fire a female employee, though she did nothing wrong, because his wife was concerned about their relationship. Although critics maligned the decision as manifestly unfair, it is consistent with the case law. But one can envision fact patterns that might lead to a different outcome.
Nelson was a stellar dental assistant for Knight for 10 years. At some point they began texting about such innocuous matters as their children’s activities. Nelson (age 32) said she saw Knight (age 53) as a father figure and never sought an intimate relationship. Knight’s wife learned of the texts, however, and demanded that he fire Nelson. He did so, in part because of that demand, but also because he said he wasn’t sure he could avoid trying to have an affair with her otherwise.
Iowa law, on this point, is modeled after Title VII of the 1964 Civil Rights Act, which prohibits employers with at least 15 employees from discriminating against an employee because of his or her sex. To have a viable disparate treatment claim, a plaintiff must prove that he or she suffered an adverse employment action (e.g., termination or a promotion denial), and that sexual identity was a motivating factor in the action. A claim for disparate impact discrimination lies where an employer has a facially neutral practice that has a disproportionately negative impact on a specific gender and is not justified by business necessity.
Nelson advanced a straightforward “but-for” argument: she would not have been fired but for her gender. Knight said she was fired because of the perceived threat to his marriage. Nelson countered that the threat would not have existed had she not been female. After reviewing cases holding that an employer does not violate Title VII by firing a female employee involved in a consensual relationship that has triggered jealousy, although the relationship and jealousy presumably would not have existed had the employee been male, the court upheld the district court’s decision to grant summary judgment for Knight.
The ruling has been criticized on a number of grounds. One is that it sends the message that men cannot be held accountable for their sexual desires and women have to monitor and control their bosses’ urges; if these urges get out of hand, women can be legally fired. In the end, however, the court found a distinction between an isolated personnel decision based on personal relations (assuming no coercion or quid pro quo), even if the relations would not have existed had the employee been of the opposite sex, and a decision based on gender itself. The court also stressed that Knight hired Nelson and also replaced her with a woman, which indicates that sex did not motivate the termination decision.
The Knight court relied on Tenge v. Phillips Modern Ag. Co., where a business owner fired a valued employee at the urging of his wife. The difference was that Tenge “came on” to the owner so there were grounds for the wife’s suspicion of an intimate relationship. Noting that sexual favoritism – treating an employee better than the opposite sex because of a consensual relationship with the boss – does not violate Title VII because any benefits of the relationship are due to the employee’s sexual conduct, not gender, the court implicitly reasoned that treating an employee unfavorably due to such a relationship is legal.
In Platner v. Cash & Thomas Contractors, Inc.,which was also cited, an employer fired a female employee who worked on the same crew as his son after the son’s wife became jealous of her. Concluding that the owner was faced with an escalating family conflict that he resolved by firing a non-relative instead of his son, the court found that Platner was fired, not because of her gender, but because of favoritism for a close relative. Nepotism is unfortunate, said the court, but it does not violate Title VII.
All of these courts stressed, as others have, that Title VII is not a general fairness law and an employer does not violate it by treating an employee unfairly as long as he or she does not act because of the employee’s protected status. This echoes U.S. Supreme Court Justice Scalia’s admonition in a 1998 sexual harassment case that Title VII is not a general workplace civility code. It is also consistent with the approach taken in a 2010 age discrimination case, where the U.S. Supreme Court held that a plaintiff can prevail only if he or she proves that age was not just a motivating factor in his or her termination, but the sole, or but-for, cause.
Nelson did not claim sexual harassment, although Knight engaged in questionable conduct, e.g., telling her that if she saw his pants bulging, she would know her clothing was too revealing, and saying, regarding her infrequent sex life, that it was like having a Lamborghini in the garage and never driving it. Sexual harassment is a form of sex discrimination. It may be quid pro quo, where a tangible employment action is conditioned on the granting of sexual favors, or a hostile environment, where an employee is subjected to conduct that is unwelcome and sufficiently severe or pervasive to alter the conditions of one’s employment. Possibly, Nelson did not assert this claim because there was no evidence of an explicit or implicit quid pro quo or conduct that was non-consensual, unwelcome, severe, or pervasive in nature. Different facts, however, could support such a claim.
The outcome might also be different if one fires several female employees because his wife was jealous of them; then, one might infer that gender, not the relationship, was the cause of the terminations. This could fit into the disparate impact category. One could also run afoul of the gender stereotyping theory, which establishes that sex discrimination occurs if an employer evaluates employees by assuming or insisting that they match the stereotype associated with their group.
Recent case law is replete with examples of courts reading the “because of sex” language with increasing exactitude, largely due to the fear of making a Title VII case out of every arbitrary or unfair employment decision. The Knight case is consistent with this approach. What happened seems unfair, for had Nelson not been female Knight wouldn’t have had the feelings he had and she wouldn’t be out of a job. It is also, arguably, unsound business practice to fire a top-flight employee for the reasons Knight offered. In the end, however, the case reinforces the fact that unfair is one thing and illegally discriminatory is quite another.
An entrepôt during its colonial era, Hong Kong has retained its strategic position as a trading hub in Asia and a gateway to China. With constant reinforcement of the “one-country, two-systems” principle, which is set to continue until 2047, the uncertainties that surrounded the 1997 handover have largely been removed, and while its long-term future may be uncertain, Hong Kong continues to have one of the most stable, effective, and certain legal systems in the world. With over 250 million tons of goods passing through it each year, and its proximity to China’s Pearl River Delta, one of the world’s worst intellectual property (IP) piracy and counterfeiting hotspots, Hong Kong is strategically important for all IP owners.
Under the “one-country, two-systems” principle, Hong Kong’s constitution, the “Basic Law,” specifically provides that Hong Kong should, on its own, develop appropriate policies and afford legal protection for IP rights. Therefore, despite being part of China, Hong Kong and China have separate legal systems. IP rights registered in Hong Kong will not be automatically protected in mainland China, and vice versa.
What Is Intellectual Property?
IP rights are proprietary rights granted to protect original products of creation. They are intended to encourage and reward creativity and fair competition in the marketplace. IP rights can be relied upon to prevent others from using one’s trademark, patented invention, copyright work, or design without consent. IP is territorial in nature and exists for set periods of time.
Hong Kong has had an English legal system for over 150 years, which was retained on the 1997 handover to China. The courts still rely on a great deal of English case law, and proceedings (whether administrative or judicial) can be conducted in either English or Chinese. Although its English legal system makes Hong Kong an ideal stepping stone for doing business in China, IP owners will need to pay extra attention to a number of issues that are unique to this city that stands between the East and the West.
Trademarks
What Is a Trademark?
A trademark can be a word, phrase, symbol, shape, color, sound, smell, or a combination of these used to identify a product or service. It functions as a badge of origin, helping consumers distinguish the products and services of one trader from those of another. In other words, a trademark helps consumers answer the questions “Who makes this product?” and “Who provides this service?” Word marks in Hong Kong can be in any language or dialect, and can be in Latin or Chinese characters. They can be transliterated between English and Chinese based on how they sound, or based on their meaning or some description of their characteristics or aspiration, or a combination of the two.
How Are Trademarks Protected in Hong Kong?
Trademarks that are used, or intended to be used, in Hong Kong can be registered with the Hong Kong Intellectual Property Department (IPD). The IPD does not differentiate between local and foreign proprietors.
Trademarks are registered in relation to particular goods or services. The Nice Classification, which is used internationally, sets out 45 classes of goods and services. In the majority of cases, an application will only be considered if the applicant is using or intending to use the mark on, or in relation to, the goods or services for which registration is sought. The system is a “first to use” system. Rights to a mark are determined on the basis of first use rather than registration. While an unregistered mark will be capable of protection, enforcement and commercialization will be easier and more satisfactory if the mark is registered.
Is My Trademark Registrable?
A trademark is not registrable if it is:
Merely descriptive (e.g., “Lavender Soap” for lavender-scented soap) or not sufficiently distinctive – unless you can show that the mark has acquired distinctiveness through extensive use;
Contrary to public policy or likely to deceive or confuse the public; or
Applied for in bad faith.
The trademarks examiner will also search the IPD’s register for any conflicting prior applications or registrations. The examiner will object to an application if the subject mark is too similar to a mark that is already on the register.
How Long Does Registration Take?
If the application is straightforward, the IPD is usually able to register the mark within six months of the date of filing. If the examiner raises objections, or third parties formally oppose the application, then the registration process will generally take longer.
An Examination Report is usually issued two months after the application is filed. The report informs the applicant whether the trademark applied for satisfies the requirements for registration. If no objections are raised by the examiner, the mark will be published in the Hong Kong Intellectual Property Journal. Third parties are then given three months from the date of the publication to lodge objections. If none is raised, the application will be entered onto the register, and the registration will take effect from the date the application was filed.
If a third party files an opposition, and the applicant either subsequently withdraws its application or is not successful at an inter-party hearing, the applicant may have to pay the opponent’s costs of the opposition.
Do I Have to Use My Trademark?
In general, yes. If a registered mark has not been used for a continuous period of three years without a valid reason, the registration may be challenged by third parties and revoked, in full or in part.
However, in some cases it may be possible to show that an international mark is “exceptionally well known” within Hong Kong, even though it is not used here. It can then be registered defensively in order to prevent misappropriation by third parties.
How Long Does a Trademark Registration Last?
With continued use, trademarks can last indefinitely, but must be renewed every 10 years.
What Rights Do I Receive upon Registration?
A registered trademark gives the registrant exclusive rights to prevent others from:
Using a mark identical to the registrant’s mark on or in relation to identical goods or services;
Using a mark identical or similar to the registrant’s mark on or in relation to identical or similar goods or services, where there is a likelihood of confusion on the part of the public; and
Using a mark identical or similar to the registrant’s mark in relation to identical, similar, or dissimilar goods or services if the use takes unfair advantage of or is detrimental to the distinctive character or reputation of the registrant’s mark – but only if the registrant’s mark is “well known.”
If a trademark is unregistered, it may still enjoy legal protection. This can be achieved by bringing a passing-off action. In order for a passing-off action to be successful, a plaintiff needs to show:
Goodwill or reputation in its mark;
A misrepresentation by the defendant causing confusion to consumers; and
Damages.
This is likely to involve extensive civil litigation, and is clearly more burdensome and difficult than merely being able to point to a registration. A registered trademark grants prima facie exclusivity and saves the mark owner a lot of trouble in the long run.
What If I License My Trademark?
Licensing trademarks is an important part of manufacturing, sale, distribution, merchandising, and franchising of goods.
The license should be registered with the IPD; otherwise the licensee will not be entitled to claim damages in an infringement action.
Patents
What Is a Patent?
A patent gives its owner (properly called a “patentee”) the exclusive right, for a limited period, to prevent others from exploiting the invention without permission. In exchange for this right, the applicant must disclose to the public how to carry out the invention in order to promote further advancement in the field.
Patents in Hong Kong are granted to the first person to file an application, rather than necessarily the first person who created the invention. Therefore, inventors can lose out if they do not patent quickly enough. Patents are territorial rights: a Hong Kong–registered patent confers exclusivity only within Hong Kong. Like other forms of property, patents can be bought, sold, and licensed.
Is My Invention Patentable?
To be patentable, an invention must:
Be new; that is, it must never have been made public in any way, anywhere in the world, before the “priority date” (the date the patent application is filed, or up to one year prior to that date where a suitable “priority document” has been filed somewhere else in the world);
Involve an inventive step over what was known at the priority date – i.e., it must not be obvious to someone with good knowledge and experience of the subject (known as a person skilled in the art); and
Be capable of industrial application; that is, it must take some practical form and be capable of being made or used in some kind of industry. So, while the invention need not be technically or commercially beneficial, impossible or futuristic inventions like perpetual motion machines are not allowed.
There are also some things that are specifically excluded. These include scientific discoveries, scientific theories or mathematical methods, aesthetic creations, schemes or methods for performing a mental act or playing a game, presentations of information, methods of treatment of humans or animals, and new animal or plant varieties.
How Do I Obtain a Patent in Hong Kong?
Patents in Hong Kong are essentially re-registrations of foreign patents. There is no substantive examination performed by the IPD. The grant of a standard patent in Hong Kong is based on the registration of a patent granted by one of three “designated patent offices”:
The State Intellectual Property Office, People’s Republic of China (PRC).
The European Patent Office, in respect of a patent designating the United Kingdom.
The United Kingdom Patent Office.
The whole process will usually take between three and five years. Hong Kong also has a “short-term” patent for which there is no substantive examination. The applicant need only comply with formalities and submit a search report obtained from one of the designated patent offices. A grant of a short-term patent is therefore much quicker and cheaper than for a full-invention patent; however, anyone can see the search report, which will not necessarily be favorable to your client.
How Long Does Patent Protection Last?
Standard patents in Hong Kong are protected for a maximum period of 20 years. Short-term patents are granted for a maximum period of eight years.
What Rights Do I Receive?
Once a patent has been granted, the patentee is entitled to take legal action against others who infringe upon the monopoly granted with respect to the invention. In this way, the patentee can prevent the unlicensed manufacture, use, importation, or sale of a product incorporating the patented invention. This right can be used to develop a business based on the invention, or it can be assigned or licensed to another person or company.
Once Granted, Is My Patent Safe?
Not necessarily. A patent may be attacked during its life for a variety of reasons, including that the invention is not new, that it is obvious, or that it does not have industrial applicability. In particular, since short-term patents are not substantively examined, they are more likely to be challenged and it is up to the patentee to prove their validity.
There are, however, some limits on the patentee’s rights. For instance, private acts done for noncommercial purposes and experiments into the subject matter of the patent will not count as infringements.
Registered Designs
What Is a Registered Design?
Registered designs – the equivalent of design patents in the PRC – are registered monopoly rights that protect the appearance of the whole or part of a product. Product features such as lines, contours, colors, shapes, texture, material, and ornamentation can be protected by design registration.
There is no provision for the protection of unregistered designs in Hong Kong.
How Do I Apply?
A completed application must be submitted to the IPD accompanied by representations of the product that clearly illustrate the features to be registered. The representations may be design drawings or just photographs of the product.
To qualify for protection, a design must:
Be new; that is, it must not be the same as any design that has already been made available to the public; and
Concern the aesthetic appearance of the product to which it is applied. Designs that are primarily functional will not be registrable.
What Rights Do I Receive?
Registered designs are protected for a maximum period of 25 years. The registration is renewable for five-year periods.
The owner of a registered design has the exclusive right to prevent others from using (including making, selling, and importing) goods made to the same or substantially the same design, and also to stop them from producing tools used for making such goods. The owner cannot, however, restrain infringing acts that are carried out for noncommercial, educational, or research purposes.
Copyright
What Does Copyright Apply To?
Copyright protects a wide variety of original works, including those embodied in books, photographs, paintings, sculpture, music, drama, records, films, CDs, videos, architecture, computer software, broadcasts, and the typographical arrangements of published works. Copyright can apply even where the work is computer generated.
Do I Need to Register Copyright?
Copyright arises automatically in Hong Kong when an eligible, original work is made. There is no need or provision for any form of registration. Because of this it can be difficult to prove ownership and is, therefore, important to keep proper records.
Under the Berne Convention, works protected by copyright in other Berne member states are automatically protected in Hong Kong.
What Does Copyright Provide?
Copyright does not protect against the independent development of the same ideas; it protects only against actual copying. In the case of complex works, it may be possible to infer copying from the quantity and exactness of the various copied features.
Also note that, in general, copyright will only protect the expression of an idea, not the idea itself. The extent to which this applies, however, depends on the detail of the idea, how it has been set out, and how much of it has been copied.
A copyright owner is able to prevent the unauthorized use of its work, such as the making of copies of the whole or substantial parts of the work, use of the work on the Internet, or translation or adaptation of the work.
There are other rights related to copyright that creators may enjoy in parallel with copyright. For instance, “moral rights” include the right to be identified as the author of a work and to object to its derogatory treatment.
How Long Does Copyright Protection Last?
In Hong Kong, copyright protects literary, dramatic, musical, or artistic works for the author’s lifetime plus 50 years thereafter. Sound recordings and broadcasts are protected for 50 years from the year of first publication and films are protected for 50 years from the year in which the last principal director, author, or composer dies. Typographical arrangements of published works are protected for 25 years from the year of first publication.
Confidential Information
Confidential information, such as industrial and commercial secrets and know-how, is by its very nature highly sensitive. In some cases, confidential information can be the most valuable asset of a business – witness the formula for Coca-Cola.
Unlike the other rights, rights in confidential information will usually derive from confidentiality agreements (often known as NDA or nondisclosure agreements) rather than from legislation. In this context, any misuse or misappropriation of the information will be actionable as a breach of contract.
However, an action for breach of confidence per se can arise where a third party discloses certain identifiable information that it has received in circumstances that imposed an obligation of confidence.
Businesses with confidential information as assets should take the necessary steps to protect this information. These may include:
Ensuring that staff do not disclose any information to persons who do not “need to know,” whether inside or outside the workplace;
Imposing nondisclosure obligations for a period after the employees resign from and leave the business; and
Requiring possible business partners to sign an NDA prior to disclosure.
In a nutshell, do not rely on implied confidentiality. It is safer to buttress confidential information with contractual obligations; breach of contract will be easier to establish and contractual damages will often be higher than those awarded for breach of confidence.
Remedies include damages, injunctions (it is important to contain the confidential information before its further release), account of profits, delivery up of all materials containing confidential information (i.e., handing them over to the owner), or destruction of such materials under oath.
Domain Names
All domain names ending in “.hk” are governed by the Hong Kong Internet Registration Corporation Ltd.; international domain names such as “.com” are governed by the Internet Corporation for Assigned Names and Numbers (ICANN). Both organizations operate a dispute resolution service to resolve cases of squatting (unauthorized use of a third party’s mark in the domain name) and misleading domain names, without having to turn to litigation. Usually, squatting amounts to passing-off (see above at “Trademarks”), but in the vast majority of cases, using the dispute resolution service is quicker and cheaper than going to court (although there is no provision for the recovery of costs).
In each case, the governing body may order the transfer of a domain name if:
It is identical or confusingly similar to the complainant’s Hong Kong trademark;
The registrant has no rights or legitimate interest in the domain name; and
The domain name was registered and is being used in bad faith.
Enforcement
Registration of IP rights can have a deterrent value in itself, but to derive the full benefit of IP rights, it is necessary to enforce them.
In Hong Kong, IP owners often learn of infringements through investigations by their own employees or by sightings referred by their lawyers, consultants, or investigators. After learning of the infringement, it is normally best to conduct an investigation to determine how bad the problem is and who is responsible for it. A good investigation will reveal the following:
Who and where the infringer is;
Whether the infringer manufactures and/or sells the goods;
The volume of infringing goods produced/sold; and
The possible location of the goods.
A low-key and low-cost first step in enforcing IP rights is simply to write to the infringer setting out the case, and demanding that it cease the infringing activity. The letter will normally also request an undertaking not to infringe further. The signed undertaking can be relied on if the infringer recommences infringing activity in the future. The downside is that unless written very carefully, such a letter, if unjustified, can constitute an actionable threat that will enable the recipient to commence proceedings for damages.
If, however, the infringer does not provide a positive response, or if the infringing activities continue, it may be necessary to enforce IP rights through the courts.
Damages awarded by the courts will rarely compensate the plaintiff in full for the damage suffered or for the full costs of the legal action. In many cases, it may be more advantageous for IP owners to seek to resolve the dispute by negotiation. In any particular case, the best approach should be carefully considered and determined in consultation with legal or other professional advisers.
Conclusion
In Hong Kong, trademarks, patents, designs, and domain names can be registered, whereas copyright does not require registration. It is necessary to determine the necessary scope of protection as products and services often embody a number of IP rights.
Registration of IP rights in Hong Kong is territorial in that they do not extend to China, and vice versa.
Every year since 1995, Hong Kong has been voted the world’s freest economy by the Heritage Foundation and the Wall Street Journal’s Index of Economic Freedom. It also has one of the lowest tax rates in the world. According to the Paying Taxes 2013 study conducted by PricewaterhouseCoopers and the World Bank Group, Hong Kong is the fourth-easiest place in the world to pay taxes, just behind three countries in the Middle East. Hong Kong is ideally located in the heart of Asia and serves as a gateway to and from Mainland China. Moreover, Hong Kong signed the Closer Economic Partnership Agreement (CEPA) with Mainland China and is treated more favorably than other foreign investors in many aspects. These advantages make Hong Kong an attractive place for foreign investors.
Hong Kong is an important location for U.S. interests. According to the U.S. Department of State, as of 2012, there are some 1,400 U.S. firms, including 840 regional operations (315 regional headquarters and 525 regional offices), and over 60,000 American residents in Hong Kong. According to the U.S. Department of Commerce, as of February 2013, Hong Kong is the United States’ seventh-largest trading partner in terms of imports from the United States, while Mainland China is third.
This article gives an overview of the major issues that U.S. investors should consider when setting up a company in Hong Kong.
The Companies Ordinance (the CO) is the main piece of legislation governing companies in Hong Kong. The CO is being completely rewritten, and the new CO will come into force in the first quarter of 2014. Where changes will be brought about by the new CO regarding the issues discussed in this article, the new CO provisions will be introduced as well.
Types of Permitted Operations in Hong Kong
Depending on the scope of operations, foreign companies seeking to operate in Hong Kong have three alternative permitted forms of business presence.
Representative Office
A representative office is suitable for a foreign company that intends to conduct only minimal activities in Hong Kong. A representative office cannot conduct any trade, professional, or business activities or transactions in Hong Kong and cannot enter into any contracts in Hong Kong. A representative office is appropriate, for example, for acting as a liaison office without creating any binding business obligations.
Branch Office
If a foreign company establishes a place of business in Hong Kong, it will require registration as a foreign company under the CO. A “place of business” includes a place used by a company to transact any business that creates legal obligations. The foreign company is liable for the debts and liabilities of its Hong Kong branch, and a branch office cannot take full advantage of Hong Kong’s tax benefits.
Hong Kong Subsidiary
Due to the limitations of a representative office and branch office as described above, a foreign company usually favors establishing a Hong Kong–incorporated company as a subsidiary to operate in Hong Kong. This is generally the preferred type of business structure because the entity may be sued only to the extent of the limited assets of the Hong Kong subsidiary.
Classification of a Company
Under the CO, a “private company” is a company that restricts the right to transfer its shares, prohibits public subscription for its shares or debentures, and limits the number of shareholders to 50. Any company which cannot satisfy all three requirements is a public company. A public company can be listed on a stock exchange or unlisted. This article does not discuss public companies.
A company can also be classified by whether it is limited by shares or by guarantee, or is an unlimited company. This article focuses on a company limited by shares, which is the most common type and is usually referred to as a “limited company.” A company limited by guarantee in Hong Kong is usually a nonprofit organization.
The new CO makes it clear that there are five types of companies that can be set up under the CO:
A public company limited by shares;
A private company limited by shares;
A public unlimited company with a share capital;
A private unlimited company with a share capital; and
A company limited by guarantee without a share capital.
Requirements for a Hong Kong Private Company
At a minimum, a Hong Kong private limited company must have the following:
One shareholder;
One director;
A company secretary;
A registered office address in Hong Kong;
An auditor; and
A business registration certificate.
Director
A director must be at least 18 years of age, must not be an undischarged bankrupt, must not be subject to a disqualification order, must comply with any share qualification requirement, and must consent to act. There is no restriction on the nationality of a director.
A private company can have a director that is a corporation, but under the new CO, a private company must have at least one director who is a natural person (but a company that is a member of a group of companies of which a listed company is a member cannot have any corporate directors).
Company Secretary
A company secretary must be either an individual resident in Hong Kong or a company with a registered office or place of business in Hong Kong.
Business Registration Certificate
A one-stop Company and Business Registration Service has been launched by the Companies Registry and the Inland Revenue Department. Applications for both incorporation and business registration may now be undertaken simultaneously.
In addition to the business registration certificate, certain types of businesses may need additional forms of licensing. For example, a company conducting regulated financial services activity (such as asset management, dealing in securities, or advising on securities) in Hong Kong requires licenses from the Securities and Futures Commission.
Generally
There is no prescribed minimum paid-up capital. Under the new CO, the concept of nominal or authorized share capital and nominal or par value will be abolished. Instead, the articles of the company with a share capital must include a statement of capital containing some prescribed information and the initial shareholdings.
The same person can be the secretary, director, and shareholder of a company, except that the sole director of a company cannot also be the secretary of the company.
A company’s statutory records should be kept at its registered office. If they are kept at a different place, a notice must be filed with the Companies Registry.
Under the new CO, the memorandum of association will be abolished as the constitution of a company. The articles of association will be the sole constitutional document of the company. Moreover, it will no longer be compulsory for companies to have a common seal. There are new provisions for execution of documents by authorized signatories where the document would take effect as if executed under seal.
Information Available to the Public
Compared to other jurisdictions (e.g., the British Virgin Islands and the Cayman Islands), Hong Kong companies are much more transparent in terms of information that is available to the public. In addition to basic information, one can search for all the documents filed with the Companies Registry in relation to a particular company. One can also search for the registered charges of a company and disqualification orders made. Moreover, one can search for all the companies in which an individual has directorships and the particulars of that director, such as his or her identity number and residential address.
It was originally proposed under the new CO that the residential address of a director and the full identification numbers of any person would not be made available for public inspection. This new arrangement has been subject to a heated public debate over the balance between personal data privacy and information transparency. The implementation of this new arrangement has now been delayed, and will not come into force along with the other provisions under the new CO.
Establishing a Private Company
There are two ways of establishing a private company in Hong Kong: incorporating a new company or buying a shelf (or existing) company.
Incorporation involves applying to the Companies Registry, which then issues a certificate of incorporation within four working days after submission of the application by post (online applications may be processed within an hour). The newly incorporated company then needs to be activated by holding its first board meeting and a shareholders’ meeting, if necessary.
Buying a shelf company is useful when a company is urgently needed. One just needs to acquire a shelf company and then activate it by effecting a change of shareholders and directors and holding a board meeting (and a shareholders’ meeting, if necessary).
Continuing Compliance Requirements
A company should hold an annual general meeting (AGM) each year, and not more than 15 months from the previous AGM, unless everything that is required to be done at the meeting is done by written resolution and the relevant documents are provided to each member. The following matters are usually dealt with at the AGM:
Adoption of audited accounts comprised of the balance sheets, directors’ report, and auditors’ report;
Declaration of dividends;
Election of directors; and
Appointment of auditors.
The new CO provides that a company is not required to hold an AGM if it has only one member or the AGM is dispensed with by unanimous members’ consent.
Other compliance requirements include, among others, the following:
A company should keep a register of members and a register of directors and secretaries;
Various returns have to be filed with the Companies Registry within stipulated deadlines for changes in relation to the company, such as changes in directorship and secretary, registered office, share capital, etc.;
A company must file an annual return;
A company must have annual audited accounts. The CO prescribes detailed requirements regarding the types of accounts to be prepared. A directors’ report must also be prepared in conjunction with the annual accounts;
Shareholders’ or board meetings should be held as may be necessary or required under the CO. The minutes or written resolutions should be filed in a minute book and resolutions or notices should be filed with the Companies Registry as required under the CO; and
A company also needs to renew its business registration certificate before it expires and file profit tax returns for the company and the employer’s return for its employees with the Inland Revenue Department.
If a company fails to comply with these requirements, the company and every officer of the company who is in default may be liable for a fine and/or imprisonment.
Tax Issues
Profits Tax
Hong Kong adopts a territorial corporate tax system. Corporations are taxed on profits at a rate, for assessment year 2012/2013, of 16.5 percent. Profits tax is charged on Hong Kong–sourced profits and is collected by the Inland Revenue Department. The tax rate on profit derived in Hong Kong is the same for Hong Kong and foreign companies.
Specifically, domestic and foreign entities meeting the following three criteria are subject to profits tax:
The entity carries on a trade, profession, or business in Hong Kong;
The profits are from such trade, profession, or business carried on by the entity in Hong Kong; and
The profits arose in, or were derived from, Hong Kong.
A Hong Kong resident may derive profits from abroad that are not subject to Hong Kong profits tax; conversely, a nonresident may be liable for tax on profits arising in Hong Kong. The question of whether a business is carried on in Hong Kong and whether profits are derived from Hong Kong is largely one of fact. Profits arising from activities conducted abroad, even if they are remitted into Hong Kong, are not subject to profits tax.
Salaries Tax
Income received by employees from Hong Kong–sourced employment is subject to salaries tax. Subject to certain exemptions, income subject to salaries tax includes salaries, wages, commissions, tips, bonuses, allowances, perquisites, leave pay, terminal/retirement awards, contract gratuities, and noncash benefits such as housing allowances and stock-based awards.
In determining assessable income, outgoings and expenses (other than expenses of a domestic or private nature and capital expenditure) wholly, exclusively, and necessarily incurred in the production of the assessable income and depreciation allowances in respect of the plant and machinery, the use of which is essential to the production of the assessable income, are deductible. Other permitted deductions include:
Loss brought forward from previous years of assessment;
Expenses of self-education paid;
Elderly residential care expenses paid;
Home loan interest paid;
Contributions to recognized retirement schemes; and
Donations to approved charities.
Salaries tax is computed on net chargeable income at scaled rates between 2 percent and 17 percent for assessment year 2012/13. Salaries tax will not in any event exceed (i.e., is capped at) 15 percent of net income before allowances.
Double Taxation
The United States is absent from Hong Kong’s otherwise comprehensive double-taxation treaty network. However, Hong Kong adopts the territoriality basis of taxation, whereby only Hong Kong–sourced income or profit is subject to tax and non–Hong Kong sourced income or profit is, in most cases, not subject to tax. Accordingly, Hong Kong generally does not double-tax its residents. The Inland Revenue Department allows a deduction for foreign tax paid on turnover basis in respect of an income that is also subject to tax in Hong Kong.
General Tax Benefits
Dividends or overseas branch profits repatriated to Hong Kong are not subject to Hong Kong tax. In addition, dividends paid by a Hong Kong company to its shareholders are not subject to Hong Kong tax in the hands of shareholders (tax already having been paid by the company on the profits underlying those dividends), nor is there any withholding tax on dividends paid to shareholders outside Hong Kong. Capital gains are also tax-exempt. A stamp duty is imposed on certain documents such as share transfers, leases of real property, and sale of real property. There is no sales tax, value-added tax, or estate tax in Hong Kong.
For 2012/2013, a one-off reduction of 75 percent of the final tax payable under the profits tax, salaries tax, and tax under personal assessment, subject to a ceiling of HK$10,000 per case, was proposed in the 2013–14 financial budget. This reduction is pending legislative approval.
FATCA Issues
Under the new U.S. Foreign Account Tax Compliance Act (FATCA), all foreign financial services institutions have to report the activities of their U.S. clients to the U.S. Internal Revenue Service if assets in their offshore accounts reach US$50,000. FATCA was designed to catch tax evasion by U.S. taxpayers overseas. Foreign countries have until 2014 to come into compliance or risk sanctions by the U.S. government. As at this writing, Hong Kong does not have a FATCA compliance plan.
Employment Issues
Protection Under the Employment Ordinance
Irrespective of their hours of work, all employees covered by the Employment Ordinance (Chapter 57 of the Laws of Hong Kong) are entitled to basic protections, which include wages and statutory holidays. Employees who are employed under “continuous contracts” are also entitled to benefits such as rest days, paid annual leave, sickness allowance, severance payment, and long-term payment. An employee who has been employed continuously by the same employer for four weeks or more (with at least 18 working hours each week) is regarded as being employed under a “continuous contract.” The definition of “continuous contract” is currently under review.
Minimum Wage
Starting from May 1, 2013, the minimum wage rate in Hong Kong is HK$30 per hour.
Mandatory Provident Fund
In Hong Kong, all employers and their employees aged 18 to 65 must join an employment-based retirement pension scheme unless an exemption applies (e.g., if the employee earns less than HK$6,500 per month), or if the employee is an existing member of an overseas pension scheme. Mandatory contributions are calculated on the basis of 5 percent of an employee’s relevant income, up to a maximum mandatory contribution of HK$1,250 a month, with the employer matching the employee’s contribution.
Employment Visa Issues
As a general rule, any person, other than those having the right of abode or the right to land in Hong Kong, must obtain a visa before coming to Hong Kong for the purpose of taking up employment. This includes secondees from an overseas office.
Conclusion
This article gives an overview of the main issues relating to setting up a business in Hong Kong. One may also need to consider issues other than the ones discussed above, such as opening bank accounts, entering into leases for office premises, recruiting employees, arranging financing, and protecting trademarks and other intellectual property rights and establishing data protection policies.
Hong Kong has always been keen to attract foreign investment to reinforce its status as an international financial center. Government policies generally favor foreign investment. For example, Hong Kong and Mainland China regularly enter into new supplements to CEPA to give more advantages to Hong Kong. These are the advantages that Hong Kong has that foreign investors should consider when they decide where to establish their business.
The Peoples’ Republic of China (PRC, China, or Mainland China) is the second largest economy in the world after the United States and is the world’s fastest-growing major economy, with growth rates averaging 10 percent over the past 30 years. Since the implementation of its open-door policy in the late 1970s, China has become the world’s premier destination for foreign investment. China was the largest recipient of global foreign direct investment in the first six months of 2012. Over 480 of the Fortune Global 500 firms are doing business in China. China joined the World Trade Organization (WTO) in 2001 to enhance its competitiveness in the global market, and by 2010, China’s exports amounted US$1.19 trillion. Its main export partners are the United States (17.7 percent), Hong Kong (13.3 percent), and Japan (8.1 percent). China’s trade surplus in March 2013 amounted to US$11.19 billion.
Hong Kong is the world’s 10th largest trading economy and 11th largest exporter of commercial services. It has always had a laissez-faire policy aimed at promoting barrier-free trade. Foreign direct investment (FDI) is very active in Hong Kong. According to UNCTAD World Investment Report 2012, Hong Kong is the second largest source of FDI in Asia after Japan, with an outflow of US$81.6 billion in 2011.Hong Kong is also the key entrepôt of China. According to Hong Kong government statistics, in 2011, China was the destination of 54 percent of Hong Kong’s re-exports. A majority of the direct investments in China are implemented through Hong Kong.
Hong Kong’s Role in the Economic Development of China
In March 2011, the 11th National People’s Congress (NPC) passed the 12th Five-Year Plan for the National Economic and Social Development of PRC (12th Five-Year Plan). For the first time, PRC’s National Five-Year Plan contains a chapter on the role of Hong Kong in the development of China. It aims at:
Further consolidating and elevating Hong Kong’s competitive advantages, including its status as an international center for financial services, trade, and shipping;
Developing Hong Kong into an international asset management center and offshore renminbi (RMB) business center, so as to strengthen its global influence in the financial sector; and
Nurturing emerging industries and facilitating extending their fields of cooperation and scope of service in China.
In response to the 12th Five-Year Plan, the Hong Kong government encourages its enterprises to tap into the China market with emphasis on promoting Hong Kong’s role as an offshore RMB business center. As for industrial development, the Hong Kong government set up the Financial Services Development Council to promote Hong Kong’s financial services industry and complement the internationalization of RMB and Mainland China’s financial market.
Hong Kong has become a conduit to funnel capital, high-caliber talent, and technology into China from all over the world, while also introducing China’s enterprises, products, and services to the global market. In essence, Hong Kong provides a springboard to China’s strategy of “going out” and “bringing in.”
Advantages of Doing Business in China via Hong Kong
Hong Kong is the largest foreign direct investment source in China. As of June 2011, there were 3,752 regional headquarters and regional offices in Hong Kong representing their parent companies located outside Hong Kong, with an increase of 3.1 percent from the previous year. Of these companies, 81 percent were responsible for business in China, confirming Hong Kong’s role as a gateway to China.
Robust Legal System
Hong Kong was a British colony from 1842 to 1997. After the handover in 1997, the “Basic Law” has been the supreme law of Hong Kong. Its underlying principle of “one country, two systems” enacted by the NPC indicates that the prior colonial-era capitalist system and way of life are to remain unchanged for 50 years. The most prominent feature of the Basic Law is the upholding of the common law system and rule of equity. Also, all ordinances not contradicted by the Basic Law are to remain in force. Hong Kong has a robust legal system and an independent judiciary that provide a fair and just operating environment for businesses. Under the Basic Law, Hong Kong has its own final appellate body, the Court of Final Appeal, which is crucial in maintaining the independence of the judiciary. Over the years, it has invited distinguished overseas judges to sit on its court and assist in the development of local jurisprudence. For example, Sir Anthony Mason, a former chief justice of the High Court of Australia, frequently sits in the Court of Final Appeal. The same applies to many law lords from the United Kingdom. This arrangement, which is unprecedented, not only signifies Hong Kong’s determination to retain judicial independence, but, equally important, it adds an international dimension to Hong Kong’s legal system.
Availability of quality legal services is an important factor for corporations that use Hong Kong as a regional center. Hong Kong is a one-stop professional advisory services center with over 7,400 practicing solicitors, 1,100 barristers, and more than 33,000 certified public accountants. Over 1,400 foreign lawyers qualified in 29 different overseas jurisdictions are practicing in Hong Kong and are capable of counseling on matters pertaining to the laws of the United Kingdom, United States, China, and others. In recent years, leading U.S. law firms have established bases in Hong Kong, making it a true international legal hub. According to statistics published in the October 2012 issue of American Lawyer, out of the top 100 global law firms ranked by revenue, 65 have offices in Hong Kong, and 50 of them are practicing as local Hong Kong firms of solicitors.
The in-depth knowledge of Hong Kong legal practitioners in the Mainland China market and Hong Kong’s regulatory framework facilitate transactions involving parties from China by acting as a bridge between clients from the international and China capital markets. Also, sophisticated legal services are provided for fund-raising, finance, securities, international trade, and cross-border transactions.
Effective Dispute Resolution
In addition to a fair and efficient judicial system, alternative dispute resolution mechanisms to deal with business disputes are available. Hong Kong provides highly cost-effective arbitration services. In June 2011, Hong Kong reformed its Arbitration Ordinance Cap. 609; it now has a unitary regime of arbitration based on UNCITRAL Model Law for all types of arbitration, abolishing the distinction between domestic and international arbitration.
Under Mainland Judgments (Reciprocal Enforcement) Ordinance Cap. 597, certain commercial judgments by either the China or Hong Kong courts may be enforced reciprocally. Arbitration awards made in Hong Kong are enforceable in more than 140 jurisdictions through the New York Convention and the Arrangement Concerning Mutual Enforcement of Arbitral Awards between China and Hong Kong.
In Noble Resources Limited v. Zhoushan Zhonghai Food and Oil Industrial Limited (2009), whereby the party applied for approval from the Supreme People’s Court of its denial of enforcement of a Hong Kong International Arbitration Centre award on the basis of public policy, the Zhejiang Higher People’s Court highlighted that “there has not been any precedent of denying enforcement of HKIAC awards in the Mainland.” The Supreme People’s Court enforced the award finding in favor of the foreign party.
With sophisticated legal expertise, internationally recognized regulatory standards, an independent judiciary, and an effective alternative dispute resolution system, Hong Kong is truly a one-stop hub in Asia that provides efficient and wide-ranging services that meet the needs of different kinds of businesses at different stages of development.
Mainland–Hong Kong Closer Economic Partnership Arrangement
Hong Kong enjoys a unique advantage under the Mainland–Hong Kong Closer Economic Partnership Arrangement (CEPA), which was first concluded in June 2003, with the latest supplement effective on January 1, 2013. CEPA plays an important role in strengthening cooperation between Hong Kong and China in areas of finance, trade, and investment facilitation and in promoting joint prosperity and development of the two entities. Prominent preferential liberalizations for goods and services of Hong Kong to enter the China market were announced. It is expected that free service trade between the two entities will be further promoted in the coming supplements. The liberalizations under CEPA provide better terms than the WTO commitments of China, adding to the desirability of Hong Kong as a base for doing business in China.
All products “made in Hong Kong” complying with CEPA origin rules and upon application by local manufacturers, except for a few prohibited articles, can be exported to China tariff-free under CEPA. “Made in Hong Kong” means goods must be “substantially transformed” in Hong Kong with at least 30 percent of value added therein (including R&D and design costs). Since the implementation of CEPA, the number of goods eligible for tariff-free treatment increased from 273 to 1,739.
International firms that incorporate in Hong Kong enjoy all the benefits available under CEPA, as well as the obvious geographic advantage of being located in Hong Kong, which facilitates connecting with suppliers and consumers in China.
Also, Hong Kong service suppliers enjoy preferential treatment and relaxed market access conditions when setting up business in China. Financial, geographical, and ownership constraints are reduced or removed, such as allowing wholly owned operations and reducing registered capital requirements, which facilitate entrance to the China market for small to medium enterprises. Free trade in services between Guangdong and Hong Kong is expected to be achieved in 2014.
Any company can benefit from CEPA if it is incorporated in Hong Kong with three to five years’ operation (depending on the sector). Fifty percent of its staff must be employed locally and liable to pay Hong Kong tax. Overseas service providers can partner with, invest in, or buy into a CEPA-qualified company to acquire easier access to China.
Languages and Accessibility
Hong Kong has the root of Chinese cultures with British features from its colonial history. Chinese and English are both official languages in Hong Kong and are commonly used in business.
Hong Kong’s geographical location has made it the central hub of the Asia-Pacific region. It is within easy flying distance of China, Southeast Asia, India, and Australia. Hong Kong is the world’s third-busiest container port system. Hong Kong International Airport is the world’s busiest cargo gateway and two additional runways are planned to increase its capacity by 2020.
Construction for the Hong Kong-Zhuhai-Macao Bridge is expected to be completed in 2016, enhancing the economic development of the region. The Hong Kong section of the Guangzhou-Shenzhen-Hong Kong Express Rail Link is expected to be completed in 2015, strengthening economic ties between the areas, accelerating the economic integration of the Western Pan River Delta and its neighboring provinces, and increasing Hong Kong’s competitiveness.
Banking and Finance in Hong Kong
As an important banking and financial center in the Asia-Pacific region, 70 of the world’s top 100 banks are based in Hong Kong. According to the Bank for International Settlements, Hong Kong is the third-largest foreign exchange market in Asia and the sixth-largest in the world. In 2011, Hong Kong was first in the world for initial public offerings (IPO) for a third year in succession and was a prominent offshore capital-raising center for China enterprises. As at December 2011, there were 640 China companies listed in Hong Kong, making up 55.5 percent (i.e., US$1.2 trillion) of the market total. Listed companies in Hong Kong are regulated by the Securities and Futures Commission and the Hong Kong Stock Exchange, which have strong reputations and high standards for listing.
Eight licensed China-incorporated banks and five representative offices operate in Hong Kong. Some of them have set up their branches in Hong Kong, such as the Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China.
Benefits of Using a Hong Kong Holding Company
The Foreign Investment Industrial Guidance Catalogue (2011 Revision), amended by the Ministry of Commerce, came into effect on January 30, 2012. The Catalogue is a tool used by the China government to control foreign investors and divides foreign investment industries into three categories: (1) Encouraged; (2) Restricted; and (3) Prohibited.
For investment in the Encouraged category, foreign investors are generally allowed to establish wholly foreign-owned enterprises (WFOE). The Encouraged category includes mining and textile manufacturing. For investment in the Restricted category, foreign investors generally need to make their investment through a joint venture with a China partner. The foreign investor’s equity interest in the joint venture can be subject to limitation. As for industrial projects in the Prohibited category, foreign investment is not allowed, for instance, in postal services and media.
On the other hand, Hong Kong provides foreign investors freedom of investment, as the restriction and limitation control by the Hong Kong government is minimal. For example, a foreign investor can set up a company in Hong Kong to hold 100 percent of a WFOE, or to incorporate in a joint venture in China.
The benefit of this practice is that, by an appropriate shareholders’ agreement, stock option plan, or asset and business management agreement, the maintenance and management of a WFOE or joint venture can be operated at the Hong Kong holding company level, which is governed by the laws of Hong Kong, and any transfer of shareholding at the Hong Kong holding company level will not require approval by the China government.
Second, as a benefit of Hong Kong’s mature banking and finance system, the Hong Kong holding company level can conveniently obtain loans and credits.
Third, on August 21, 2006, the China and Hong Kong governments signed the Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion, which provides added incentives for international investors to enter the China market through Hong Kong. For instance, where a Hong Kong resident company disposes of less than 25 percent of shareholding in a China company and the assets of the China company are not comprised of mainly immovable property situated in China, gain derived from such disposal will be tax exempted. Without this preferential treatment, the gain would be subject to a 10 percent withholding tax. As for indirect income such as interest, dividends, and royalties, Hong Kong investors are provided with preferential treatment.
Conclusion
In brief, we have set out the advantages of using Hong Kong as a base for doing business in China, including, but not limited to, a robust legal system, a simple tax regime, a leading capital market and financial center, a regional hub, quality manpower, proximity to China, an efficient government, free trade and a free market economy, global connections, and a logistic center with efficient transportation.
In this mini-theme covering Hong Kong legal services, my fellow colleagues of the Law Society of Hong Kong will cover additional legal topics that will be of interest to you and your clients that wish to do business in China.
The real estate collapse of 2008 hurt senior mortgage lenders, but it pummeled junior lenders, whose second liens went from above to below water, almost in a heartbeat. Some homeowners, however, saw an opportunity: if a home purportedly had no value above the amount of the senior lender’s claim, why not use Chapter 7 of the United States Bankruptcy Code to value the junior lender’s secured claim at zero – effectively stripping the junior lien off of the property and leaving the home closer to the water’s surface, where the borrower might more easily start re-building equity?
Bankruptcy professionals might have thought they knew the answer to that question. Over 20 years ago, the United States Supreme Court, in Dewsnup v. Timm, barred Chapter 7 debtors from stripping a creditor’s partially-secured claim down to the value of the collateral securing it.
However, a unanimous panel of the Eleventh Circuit Court of Appeals recently found Dewsnup to be irrelevant when applied to a junior lien on collateral of insufficient value to put the second lien holder in the money. The appellate panel instead relied on one of its own pre-Dewsnup decisions, a decision some bankruptcy courts thought had been abrogated by Dewsnup. Then, by refusing to publish its opinion, the Eleventh Circuit left debtors, lawyers, and judges in a quandary from which they have yet to emerge. (The case is In re McNeal, Appeal No. 11-11352, 2012 WL 1649853 (11th Cir. May 11, 2012).)
Under the Bankruptcy Code, an undersecured creditor with an “allowed” claim (that is, a claim that is entitled to be paid out of the bankruptcy estate) really has two claims: a secured claim in an amount equal to the value of the creditor’s collateral and an unsecured claim for the remainder. For example, a lender holding a $1 million mortgage claim secured by real estate worth $400,000 would have a secured claim for $400,000 and an unsecured deficiency claim for $600,000. Moreover, the same section of the Bankruptcy Code that provides for bifurcating the lender’s claim into secured and unsecured portions also provides that, to the extent a lien secures a claim that is not an allowed secured claim, that lien is void.
Before the Dewsnup decision, therefore, a homeowner in bankruptcy might ask the court to value his or her home at less than the full amount owed on the mortgage; if the court did so, the homeowner would then ask the court to void the lien to the extent that the lender’s claim exceeded that court-determined value – a procedure informally referred to as “stripping down” the lien. The debtor might then pay that value and extinguish the lien. Of course, if the court had undervalued the property or the property later appreciated in value, the debtor, not the lender, benefited from the additional value.
In 1991, the Supreme Court, in Dewsnup, put a stop to lien-stripping in Chapter 7 cases, finding that, so long as an allowed claim is secured by a lien – even one worth less than the full amount of the claim – a debtor could not strip down the lien. Instead, the lien would survive the bankruptcy, and the lender could foreclose it even after the Chapter 7 debtor received a discharge of his or her debts. While the discharge prevented the lender from collecting a deficiency from the former debtor, the lender would, at least, benefit from any increase in the value of the real estate itself, whether by appreciation or as a result of the court’s low-ball valuation. At least two considerations weighed heavily in the Court’s ruling:
honoring the bargain between the borrower and the lender that the lien would stay with the property until foreclosure, thereby insuring that increases in property value would benefit the lender; and
observing the rule, established long before the enactment of the Bankruptcy Code, that liens survive bankruptcy.
The Dewsnup opinion may have given comfort to Lorraine McNeal’s junior lender. McNeal owed $176,413 to her first mortgage lender and $44,444 to her second, each of which held liens encumbering a home that, the parties agreed, was worth just $141,416 – less than the amount of the first mortgage, leaving the junior lien completely valueless. McNeal argued that, because the lien of the second mortgage holder did not actually secure any allowed secured claim – the junior lender’s claim was wholly unsecured – that lien was void and should be “stripped off” of her home completely.
Most courts, including bankruptcy courts within the Eleventh Circuit, had held that the Dewsnup rule against “stripping down” liens that had some value applied equally to “stripping off” liens that had no apparent value, and the bankruptcy and district courts both held against McNeal, forbidding her from stripping the second lien from her home.
However, the Eleventh Circuit found that Dewsnup did not control its decision, and it reversed, holding for the debtor. Without significant analysis, the panel decided that the case of a lien determined to have some value (Dewsnup) had no relevance to the case of a lien determined to have no value (McNeal), and, instead, applied a pre-Dewsnup Eleventh Circuit decision that had permitted a lien to be stripped off of collateral whose value was insufficient to support the second lien. The result is surprising, in part, because it splits from the opposite rulings of the Fourth and Sixth Circuits and departs from the understanding of Dewsnup found in opinions of some bankruptcy courts in the Eleventh Circuit. It also departs from the central policy arguments advanced by the Supreme Court in Dewsnup, which appear to apply equally to “strip down” and “strip off” cases: that courts should respect the lender’s bargain with its borrower and that they should preserve the long-standing practice of leaving liens unaffected by bankruptcy.
Perhaps even more confounding is the fact that the Eleventh Circuit chose not to publish its McNeal opinion. Under the Circuit’s rules, that means McNeal is not binding precedent, but may be cited as “persuasive authority.” One might sympathize with bankruptcy courts in Alabama, Florida, and Georgia as they try to determine the degree to which they should be “persuaded” by a unanimous panel decision from their controlling circuit that nonetheless is not strictly precedential. Some practitioners in those jurisdictions report that, where Chapter 7 debtors have filed contested motions to strip second liens off of their homes, the bankruptcy courts are simply holding the motions in abeyance, indefinitely, pending further guidance from the Eleventh Circuit. Meanwhile, debtors in jurisdictions outside the Eleventh Circuit have also sought to strip second liens from their property.
Guidance does not appear to be within ready reach. In January, debtor’s counsel asked the appellate panel to publish its opinion in McNeal and thereby put to rest the issue of McNeal‘s authority within the circuit. However, at the time of that request, both lender-appellees had commenced Chapter 11 bankruptcy cases, and, in February, the Eleventh Circuit therefore stayed all proceedings in the McNeal appeal, until it is notified that the bankruptcy court has granted relief from the automatic stay in the lenders’ cases.
For now, then, debtors with homes worth less than their total mortgage debt have found a friend in the Eleventh Circuit, while home equity lenders may impose stricter loan-to-value requirements as they try to weigh the risks posed by McNeal.
Key provisions of the Federal Communications Commission’s (FCC) Telephone Consumer Protection Act (TCPA) rule are scheduled to take effect in October of this year. These changes will require written consent for autodialed and prerecorded telemarketing calls and text messages to cell phones, and will require written consent for prerecorded telemarketing calls to landlines.
The TCPA has a private right of action, and recent class actions alleging violations of the law’s autodialer provisions have settled for tens of millions of dollars. The filing of TCPA complaints is on the rise, and recent court decisions have complicated the TCPA litigation landscape.
In this article, we discuss the TCPA and the FCC rules, the amendments to the FCC rules under the TCPA, and new litigation developments under the TCPA.
Background to the TCPA
Under the TCPA, it is “unlawful . . . to make any call (other than a call . . . made with the prior express consent of the called party) using any automatic telephone dialing system or an artificial or prerecorded voice . . . to any telephone number assigned to a . . . cellular telephone service.” This law was passed in 1991 and reflects the now-obsolete notion that some cell phone users must pay for incoming calls, and “automated” calls should therefore be limited.
The TCPA defines the term “automatic telephone dialing system” or “ATDS” as “equipment which has the capacity – (A) to store or produce telephone numbers to be called, using a random or sequential number generator; and (B) to dial such numbers.” It seems clear that Congress intended the law to apply to random sequential dialers and similar devices that dial numbers continuously until they obtain an answer. For example, the legislative history indicates that “automatic dialers will dial numbers in sequence, thereby tying up all the lines of a business and preventing any outgoing calls.”
In 2003, the FCC interpreted the term ATDS to include a predictive dialer, where the dialer has the capacity to randomly generate and dial sequential telephone numbers, even if that capacity has not been enabled: “A predictive dialer is equipment that dials numbers and, when certain computer software is attached, also assists telemarketers in predicting when a sales agent will be available to take calls. The hardware, when paired with certain software, has the capacity to store or produce numbers and dial those numbers at random, in sequential order, or from a database of numbers.” Many businesses use telephone systems to contact their customers that, if paired with certain software, are capable of generating and dialing sequential numbers at random.
The FCC’s TCPA Rule
The FCC has made a rule under the TCPA (TCPA Rule or Rule), which generally prohibits making telephone calls to cellular telephones using an ATDS or a prerecorded message without the prior express consent of the called party. These prohibitions apply to telemarketing calls as well as to purely informational or transactional calls such as flight updates, debt collection calls, surveys, and bank account fraud alerts.
The TCPA Rule also prohibits making a telemarketing call to a residential landline telephone using a prerecorded message without the prior express consent of the called party, unless the caller has an established business relationship with the called party.
Revisions to the TCPA Rule
The FCC has revised its TCPA Rule to require an automated, interactive opt-out mechanism for prerecorded telemarketing messages to both cell phones and landlines. The revision took effect on January 14, 2013.
In addition, effective October 16, 2013, the Rule will be revised to:
Require prior express written consent requirement for telemarketing calls made to cell phones using an ATDS or a prerecorded message, but will maintain the prior express consent requirement for non-telemarketing calls to cell phones;
Require prior express written consent for telemarketing calls made to residential landlines using a prerecorded message; and
Eliminate the established business relationship exception to the obligation to obtain consent for telemarketing calls made to residential landlines using a prerecorded message.
These revisions are intended to maximize consistency with the Federal Trade Commission’s (FTC) Telemarketing Sales Rule (TSR).
Automated, Interactive Opt-Out Mechanism
As of January 14, 2013, the TCPA Rule now requires that every prerecorded telemarketing message, whether delivered to a cell phone or a residential landline, provide an automated, interactive voice- and/or key press-activated mechanism for the consumer to request no further telemarketing calls from the seller. The mechanism must be presented, together with instructions on how to use it, within two seconds of the caller’s statement of identity at the beginning of the message. When a consumer uses the opt-out mechanism, his or her number must be automatically added to the seller’s do-not-call list, and the call must immediately terminate. When the message is left on an answering machine, it must also provide a toll-free number that the consumer may use to connect directly to the automated, interactive voice- and/or key press-activated opt-out mechanism. These new FCC requirements are consistent with those already imposed by the FTC’s TSR.
Prior Express Written Consent
Effective October 16, 2013, the TCPA Rule will require prior express written consent to deliver an autodialed or prerecorded telemarketing call to a cell phone, and will require prior express written consent to deliver a prerecorded telemarketing message to a residential landline. The Rule defines “prior express written consent” as a signed written agreement that clearly and conspicuously discloses to the consumer that:
By signing the agreement, he or she authorizes the seller to deliver, to a designated phone number, telemarketing calls using an automatic telephone dialing system or an artificial or prerecorded voice; and
The consumer is not required to sign the agreement or agree to enter into it as a condition of purchasing any property, goods, or services.
The required signature may be “obtained in compliance with the E-SIGN Act,” including via an e-mail, website form, text message, telephone key press, or voice recording.
Although these provisions do not apply to purely informational or transactional calls or messages, such as flight updates, debt collection calls, surveys, or bank account fraud alerts, an informational call that includes an upsell – such as a flight update followed by an offer inviting the consumer to upgrade to first class – would require written consent. The FCC has stated that “if the call, notwithstanding its free offer or other information, is intended to offer property, goods, or services for sale either during the call, or in the future, that call is an advertisement.”
It is also important to note that because both the FCC and courts consider a text message to be a “call” for purposes of the rules promulgated pursuant to the TCPA, the written consent requirement will apply to the delivery of telemarketing text message campaigns. It is already industry practice for companies to obtain prior express consent to the receipt of such messages; however, the signature requirement and disclosure obligations (described above) are new.
Litigation and Regulatory Actions
The TCPA allows private actions and provides for between $500 and $1,500 in statutory damages for each violation, with treble damages available for willful or knowing violations, as well as injunctive relief. The TCPA also can be enforced by the FCC and state attorneys general.
TCPA litigation has trended upward in recent years, with TCPA suits rising by 63% between 2011 and 2012. Several factors appear to be fueling this trend:
Increased consumer use of cell phones as primary phones: According to a recent Centers for Disease Control and Prevention Semi-Annual National Health Interview Survey, nearly 36% of American households used cell phones only and nearly 16% received all or nearly all of their calls on cell phones even if they also use landline telephones. Additionally, 60.1% of adults between the ages of 25 and 29 live in households that use cell phones only. Companies that rely on autodialers to contact consumers, therefore, are increasingly at risk of dialing numbers in violation of the TCPA’s autodialing prohibitions.
Increased ease of filing TCPA class action suits: In Mims v. Arrow Fin. Servs., LLC, the Supreme Court ruled that federal and state courts exercise concurrent jurisdiction over TCPA claims, thus weakening arguments that state law governs whether claims may be brought as class actions.
Defects in consent: For calls where only prior express consent is required to use an autodialer, a 1992 TCPA order by the FCC states that “persons who knowingly release their phone numbers have in effect given their invitation or permission to be called at the number which they have given, absent instructions to the contrary.” This view of what reasonably evidences prior express consent is reinforced by the TCPA’s legislative history. Nevertheless, a lack of robust controls around ensuring, for example, that prior express consent has been obtained to call a number with an autodialer may result in difficulty overcoming individual claims of a lack of consent.
Several recent court decisions have also complicated the TCPA litigation landscape, one of the most notable being the Seventh Circuit Court of Appeals decision in Soppet v. Enhanced Recovery Co., LLC, 679 F. 3d 637 (7th Cir. 2012). In Soppet, a debt collector used an autodialer to call two cell phone numbers on behalf of AT&T to collect debts owed. The numbers had been provided to AT&T by the debtors, but at the time of debt collection calls they had been reassigned to new subscribers who had not consented to receive autodialed calls. The new subscribers sued the debt collector for violating the TCPA’s prohibition on using an autodialer to call a cell phone number without the prior express consent of the “called party.” The debt collector argued that the term “called party” meant “intended recipient of the call.” The Seventh Circuit rejected this argument, holding that “called party” means the current cell phone subscriber at the time the call is made. The import of the holding is that consent to autodial a cell phone number can no longer be presumed valid day-to-day unless a reliable mechanism is in place for confirming ownership of the number prior to dialing it. At a minimum, the Soppet decision should prompt businesses to consider whether to alter their dialing strategies for consumers resident in Seventh Circuit states (Illinois, Indiana, and Wisconsin).
Chesbro v. Best Buy Stores, LP, 697 F. 3d 1230 (9th Cir. 2012), serves as a cautionary tale for businesses seeking to leverage artificial or prerecorded voice robocalls to deliver messages thought to be purely informational. After purchasing a computer from Best Buy, the plaintiff in Chesbro began receiving prerecorded phone messages about Best Buy’s rewards program. The plaintiff complained to Best Buy on several occasions about the calls and was eventually placed on its internal Do Not Call (DNC) list. Several months later, however, the plaintiff received another prerecorded phone message from Best Buy about its rewards program, which prompted the filing of a class action complaint in Washington State against Best Buy alleging violation of the TCPA’s ban on prerecorded message calls that include or introduce unsolicited advertisements or constitute telephone solicitations. The district court granted summary judgment in Best Buy’s favor, finding that the calls were purely informational courtesy calls about its rewards program. On appeal, the Ninth Circuit determined that because the calls encouraged the plaintiff to redeem rewards points, the calls were telephone solicitations, reasoning that redemption of rewards points “required going to a Best Buy store and making further purchases of Best Buy’s goods . . . [t]hus, the calls encouraged the listener to make future purchases at Best Buy.” Perhaps most significantly, the Ninth Circuit found that the TCPA did not require that telephone solicitations explicitly mention a good, product, or service “where the implication is clear from the context” and that “[a]ny additional information provided in the calls does not inoculate them.” The upshot of the ruling is that businesses should carefully review any outgoing prerecorded voice messages that are purported to be informational.
Text messaging is another area in which there has been active litigation. As previously noted, the issue of whether text messages constitute “calls” under the TCPA is well-settled, see, e.g., Lozano v. Twentieth Century Fox Film Corp., 702 F. Supp. 2d 999 (N.D. Ill. 2010); Abbas v. Selling Source, LLC, N.D. Ill. 2009; Satterfield v. Simon & Schuster, Inc., 569 F. 3d 946 (9th Cir. 2009). Recent cases have tested whether confirmatory texts – i.e., text messages sent to called party confirming the party’s choice to opt out of text messaging – violate the TCPA. Here, however, plaintiffs have not had success. As the court in Ryabyshchuck v. Citibank, 11-CV-1236 – IEG (WVG) (S.D. Ca. Oct. 30, 2012) noted, “a simple, confirmatory [text message] response to plaintiff-initiated contact can hardly be termed an invasion of plaintiff’s privacy under the TCPA. A finding to the contrary would stretch an inflexible interpretation beyond the realm of reason.” The FCC, in a declaratory ruling issued in November of 2012, generally agreed with the idea that confirmatory texts do not violate the TCPA, but included some important caveats in its ruling, including that (1) prior express consent to receive texts messages is required; (2) confirmatory texts must “merely confirm the consumer’s opt-out request and do not include any marketing or promotional information”; (3) confirmatory texts are to be the only additional messages sent to customers after they opt out; and (4) confirmatory texts should be sent within five minutes of the opt out request, as “the longer [the] delay [in sending confirmatory texts], the more difficult it will be to demonstrate that such messages fall within the original prior consent.” Significantly, the FCC did not entertain the petitioner’s argument that confirmatory texts do not violate the TCPA if an autodialer is not used to send them. Rather, the FCC implied in its order that obtaining prior express consent to receive text messages means confirmatory texts may be sent with or without an autodialer.
Given the perilous and quickly changing litigation landscape and the new FCC rules regarding consent, businesses are advised to examine their calling and text messaging practices to determine whether any changes to how they operate and obtain consent are necessary.
Lenders made millions of mortgages during the decade of the 2000s, some of which were not rigorously underwritten, and for some of which the borrowers had no hope of repaying. As the loans went into default, lenders’ losses mounted and borrowers’ woes increased. The mortgage market’s collapse led to the second greatest economic recession in the last 100 years and nearly brought the United States’ economy to its knees.
To remedy this situation, Congress and various federal agencies required lenders to assess a consumer’s ability to repay a home loan before the creditor could extend the consumer the credit. To encourage responsible lending, Congress provided for penalties where a loan was made to a borrower who did not have the ability to repay it fully. Congress also permitted the regulators to create a “safe harbor” for creditors, where it would be presumed that the borrower had the ability to repay a mortgage loan.
On January 10, 2013, the Consumer Financial Protection Bureau (Bureau) released its final Ability-to-Repay and Qualified Mortgage Rule, effective January 10, 2014. This article will look at that rule by first exploring the background and financial situation that led to the release of the rule, Congress’ statutory enactments permitting the rule, and the final rule itself.
Background
In the early part of the last decade, as housing prices rocketed skyward, lenders began introducing products that permitted borrowers to take advantage of their increasing equity. Lenders moved away from the fully-amortizing, fixed-rate, 30-year loan, and offered hybrid adjustable-rate mortgages where the initial interest rate was set at a below-market rate for a fixed period, such as two, three, five, or seven years. Lenders offered fully adjustable rate loans, where the interest rate was adjusted on a monthly or yearly basis. As the demand for loans increased, both by borrowers and investors, lenders offered loans with an interest-only payment, deferring the repayment of principal for a period of years. This permitted borrowers to obtain larger loans than could be afforded if the loans had to be repaid in equal payments of principal and interest over 30 years. Finally, the industry offered option ARM loans, where a borrower could choose to repay a portion of the interest owed, adding the remainder to an increasing principal balance.
To facilitate these loans, lenders relaxed their underwriting standards. Low-document and no-document loans proliferated. Borrowers could state their income, without offering any verification of it, and lenders would rely on the representations. Lenders would check borrowers’ credit and the value of the property, and little else. As long as the property value elevator rode upward, lenders made the loans, borrowers obtained loans, and investors bought loans.
Many borrowers took advantage of these loans, obtaining cash-out refinances. The cash-out portion may not have been used to improve the value of the property, and was often lost to repayment of other (overextended) debts, or to fund new purchases of vacations, impermanent assets, or consumables. In addition, with the advent of easier-to-obtain loans, new borrowers entered the housing market and became first-time homeowners for a small or no down payment. These borrowers often obtained loans with adjustable rate features or limited principal repayment that exposed the market to risk as payments adjusted or property values declined.
In the middle to late 2000s, the housing market slowed and reversed, and many borrowers were unable to repay their loans. As loans went into default and foreclosures increased, lenders and servicers were overwhelmed, and investors began to take losses. With the collapse of the housing market, America, and the world, entered the most serious recession since the Great Depression.
Reaction to the Housing Crisis – Ability to Repay Consideration
In 2008, the Federal Reserve Board (Board) adopted a rule under the Truth in Lending Act which prohibited creditors from making “higher-price” mortgage loans without assessing consumers’ ability to repay the loans. Under the Board’s rule, a creditor is presumed to have complied with the ability-to-repay requirement if the creditor followed specified underwriting practices.
In 2010, when Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Sections 1411 and 1412 required lenders to assess consumers’ ability to repay all home loans before extending credit and provided that the regulators could create a safe harbor and presumption of compliance with the ability-to-repay requirement for “qualified mortgages.” Congress set forth the requirements in a new section of the Truth in Lending Act, Section 129C (link here), and permitted rulemaking to interpret the act and provide guidance to the industry and consumers.
The Bureau conducted extensive research and analysis on this issue. It sought public comment on new data and information, and the Bureau met with stakeholders on all sides in formulating the rule. On January 10, 2013, the Bureau released the final rule. (See “Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z)” at www.consumerfinance.gov. See also Ability-to-Repay and Qualified Mortgage Standards under the Truth in Lending Act, Final Rule, 78 Fed. Reg. 6408 (January 30, 2013), to be codified at 12 C.F.R. § 1026.) The Bureau stated that the rule protects consumers from risky practices that helped cause the mortgage crisis. It helps ensure that responsible consumers obtain responsible loans and that creditors can extend credit responsibly, without worrying about competition from unscrupulous lenders.
Under the statute, the ability-to-repay requirements are effective as of January 21, 2013. The final rule delays the implementation of the ability-to-repay requirements until January 10, 2014. If a successful challenge is mounted to the recess appointment of Richard Cordray as director of the Bureau, the ability-to-repay provisions are effective immediately. It is unknown whether they will have a retroactive effect.
Ability-to-Repay Rule
The Ability-to-Repay Rule, Regulation Z Section 1026.43, requires that a creditor make a “reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” The creditor must follow underwriting requirements and verify the information by using reasonably relied upon third-party records. The rule applies to all residential mortgages including purchase loans, refinances, home equity loans, first liens, and subordinate liens. In short, if the creditor is making a loan secured by a principal residence, second or vacation home, condominium, or mobile or manufactured home, the creditor must verify the borrowers’ ability to repay the loan. The section does not apply to commercial or business loans, even if secured by a personal dwelling. It also does not apply to loans for timeshares, reverse mortgages, loan modifications, and temporary bridge loans.
The creditor must consider and evaluate at least the following eight factors:
Current or reasonably expected income or assets. The creditor may consider borrowers’ assets and income that borrowers will use to repay the loan. The creditor may not consider the value of the secured property, including any equity in the dwelling. Because of seasonal work, or other factors that result in variable income, the creditor may consider current income and “reasonably” expected income. A creditor may also consider a joint applicant’s income and assets.
Current employment status. The creditor must consider borrowers’ current employment status to the extent that the creditor relies on the employment income to repay the loan. If borrowers’ intend to repay the loan with investment income, employment need not be considered.
Monthly payments on the covered transaction. The monthly payment obligation is based on the “full” payment. The payment must be considered on a monthly basis, and be at the fully adjusted indexed rate or the introductory rate, whichever is higher. In short, teaser rates and other “low” starting rates are not to be considered in the ability-to-repay analysis.
Monthly payments on a simultaneous loan. The creditor must consider the “full” monthly payments on any simultaneous loan that the creditor knows or has reason to know will be made on or before consummation when secured by the same dwelling. This includes piggy-back loans, concurrent loans, and open-ended home equity loans, even if made by another creditor. The rule applies to purchases and refinances.
Monthly payments for mortgage-related obligations. The creditor must consider payments for mortgage-related obligations, according to the loan’s terms, and all applicable taxes, hazard insurance, mortgage guarantee insurance, assessments, ground lease payments, and special assessments (if known). The creditor must consider these amounts whether or not an escrow is established. Where these charges are paid on an annual or periodic basis, they are to be calculated as if paid monthly. However, where the charge is a onetime, up-front fee, it need not be considered in the ability-to-repay calculation.
Current debt obligations, alimony, and child support. The creditor must consider borrowers’ other debt obligations that are actually owed. Each applicant’s obligations are to be evaluated, but the creditor does not need to consider other obligations of sureties or guarantors. Creditors are given significant flexibility in this area and may use reasonable means to consider other debt obligations.
Monthly debt-to-income ratio or residual income. The rule gives the creditor flexibility in defining “income” and “debt” based on governmental and non-governmental underwriting standards. The rule also gives the creditor flexibility in evaluating the appropriate debt-to-income ratio in light of residual income. For example, where the debt-to-income ratio is high and the borrowers have a large income, the borrowers should have sufficient remaining income to satisfy living expenses and therefore justify the loan. The determination is subject to a reasonable and good faith standard.
Credit history. A creditor must consider borrowers’ credit histories, but does not have to review a specific credit report or minimum credit score. Creditors may consider factors such as the number and age of credit lines, payment history, and any judgments, collections, or bankruptcies. The creditors must review borrowers’ credit histories and give various aspects as much or little weight as is appropriate to reach a reasonable, good faith determination of borrowers’ ability to repay the loan.
Creditors will typically use third-party records (not prepared by the consumer, creditor, mortgage broker, or any of their agents) to make a reasonable and good faith determination, based on verified and documented information, that a consumer has a reasonable ability to repay the mortgage loan. The rule requires that the creditor retain evidence of the ability to repay for three years. However, because of possible challenges by borrowers to the ability-to-repay determination, it is recommended that creditors and their successors maintain these records for the life of the loan.
The Ability-to-Repay Rule does not apply to every loan. Principally, the rule does not apply where a non-standard mortgage (such as an adjustable rate loan, interest-only loan, or negative amortization loan) is refinanced into a standard mortgage, where the current creditor provides the refinance, the new payment will be materially (10 percent) lower, and most of the previous payments were timely. However, the ability-to-repay analysis implicitly applies to the new loan.
Qualified Mortgages
The Dodd Frank Act provided that “qualified mortgages” are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. The Bureau’s rule establishes a safe harbor and creates a conclusive presumption for loans that meet certain criteria and are not high-priced loans that the creditor made a good faith and reasonable determination of the consumer’s ability to repay. Where the loan satisfies the requirements of a qualified mortgage and is a high-priced loan, there is a rebuttable presumption that the creditor complied with the ability-to-repay requirement. Borrowers may overcome the presumption when they can show that after making all mortgage related payments there is insufficient income left over to meet living expenses. The longer it takes for borrowers to default, the more difficult it is to overcome the presumption.
A qualified mortgage includes the following criteria:
Regular substantially equal periodic payments. This does not include negative amortization loans, interest only payments, and balloon payments. If the loan does not require monthly payments, the payments are to be calculated as if paid monthly.
Term is 30 years or less.
Total points and fees to not exceed 3 percent of the loan amount. Points and fees are broadly interpreted. The 3 percent cap is adjusted as the loan balance falls below $100,000. Points and fees include all items in the finance charge as defined in the Truth in Lending Act, other than interest. The points and fees include loan originator compensation paid by the consumer or creditor, as known at the time the interest rate is set, if attributable to the transaction, whether paid to the individual loan officer or a broker. The points and fees include charges paid to the creditor, originator, or affiliate, even if the same fees would not be included if charged by an independent third party. For example, title charges by an affiliated title company are included in the 3 percent calculation, but similar charges by an independent title company are not. The points and fees included other charges as detailed by the rule. The loan amount is the amount stated in the promissory note.
Monthly payment calculated based on the highest expected payment in the first five years. The creditor must underwrite the loan based on a fully amortized payment schedule taking into account the highest adjustment of any loan payment, and all other mortgage-related payments, including taxes and insurance, whether or not impounded by the creditor.
Consider current and reasonably expected income and expenses. This includes debt obligations, alimony, and child support. The income and expenses must be verified and documented, as discussed above. This eliminates low-document and no-document loans from being qualified mortgages.
Debt-to-income ratio does not exceed 43 percent. The debt includes all mortgage-related expenses, and simultaneous mortgage-related expenses that the creditor knows or has reason to know.
If these criteria are met and the loan is underwritten with good faith and reasonable reliance on verified third-party provided documentation, then the loan is a qualified mortgage entitled to a conclusive presumption that the loan meets the ability-to-pay requirements.
Alternative Qualified Mortgages
The Bureau established a second, temporary class of qualified mortgages based on the belief that certain consumers can afford loans with a higher debt-to-income ratio of 43 percent based on their particular circumstances. In addition, the temporary class of qualified mortgages may help overcome any initial reluctance of creditors to make loans that might not be qualified mortgages. These loans may be underwritten with more flexibility, but still require a reasonable and good faith belief in borrowers’ ability to repay the loans.
These alternative qualified mortgage loans must satisfy the general product feature prerequisites for a qualified mortgage and also satisfy the underwriting requirements of, and are eligible to be purchased, guaranteed or insured by (1) the GSEs while they operate under federal conservatorship or receivership or (2) the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service. This temporary class will phase out as each agency issues its own qualified mortgage rules, or the GSE conservatorship ends, or seven years elapse.
Note that the rule does not define how the eligibility determination is made if the GSEs or federal agency does not actually purchase, guarantee, or insure the loan. Similarly, in light of the current state of repurchase litigation, even if the loan is purchased, guaranteed, or insured, it is unknown if that determination creates a qualified mortgage “presumption” that is conclusive or rebuttable.
Failure to Comply with Ability-to-Repay
A creditor must properly determine whether borrowers have the ability to repay their loans. Where a creditor does not act properly, the Bureau retains the ability to issue cease and desist orders, or impose civil monetary penalties.
The rule provides a private right of action to borrowers. They may seek actual damages, statutory damages, costs, and attorneys’ fees, and special damages equal to the finance charges and fees incurred. In short, where the creditor does not properly assess borrowers’ ability to repay loans, borrowers must repay the principal amount of the loan, less damages, and could end up with a “free” loan. Borrowers may also seek damages in class action litigation and individual cases. While current law provides for a one-year statute of limitation on damage actions, borrowers have three years to bring their ability-to-repay damage claims.
Borrowers may also assert the ability-to-repay defense in response to a foreclosure action and seek recoupment or set-off. The three-year statute of limitation does not apply, but borrowers are limited to three years of finance charges and fees as special damages. Assignees are liable for the errors of the original creditor.
Conclusion
Creditors must assess borrowers’ ability to repay a loan based on verifiable information. Creditors must act in a good faith and reasonable manner to determine whether borrowers can afford the loan(s) offered. To avoid liability under a faulty ability-to-pay determination, creditors may rely on the safe harbor of the qualified mortgage conclusive presumption. Qualified mortgages must be fully underwritten, at the maximum adjusted payment, based on verifiable information provided by third parties, to a high level of specification, even though the rule provides the creditor with discretion to make its determination. It is unknown what types of loans will be offered to borrowers and whether the loans will be purchased in the secondary market. However, it is expected that in the initial term, most residential mortgages will be low cost, fixed-rate loans, issued to very credit-worthy borrowers who meet all lending criteria. As GSEs and other agencies agree to purchase, guarantee or insure loans, the pool of available loans will expand, helping the Bureau meet its goal of ensuring that responsible consumers obtain responsible loans and that creditors extend credit responsibly, without worrying about competition from unscrupulous lenders.
We are only one quarter into 2013, but this year has already seen a flurry of multi-billion-dollar mergers and acquisitions from some of corporate America’s most recognizable names. In the past few months, airline giants American Airlines and US Airways announced they would be merging in an $11 billion deal, while Warren Buffett’s Berkshire Hathaway and global investment firm 3G Capital announced the acquisition of the H.J. Heinz Company for $28 billion. Those deals came just a week after Dell Inc. announced that company founder Michael Dell had partnered with global technology investment firm Silver Lake Partners to acquire and privatize the company in a transaction valued at $24.4 billion.
Managing the legal aspects of corporate restructuring is a difficult task. For companies that employ foreign nationals, that task is even more complicated as there are significant immigration-related consequences that must be addressed prior to sealing the deal on a merger or acquisition. Because most work visas are employer-specific, changes in a company’s structure could affect the validity of a foreign national employee’s nonimmigrant visa status or pending green card application. In addition, a company’s failure to recognize the immigration issues arising as a result of its restructuring activities can not only seriously impact its foreign national employees, but also have serious consequences for the company. Employers who fail to take the proper measures may find themselves being sued by foreign national employees for negligence in handling their immigration matters. For example, when a company’s actions cause the foreign national employees to fall out of legal status, have problems pursuing permanent residency, or even potentially face bars on reentering the United States after travel abroad, those employees may seek action against the employer. Additionally, employers with immigration violations potentially face:
Worksite raids and loss of business during the raid;
Compliance audits;
Significant fines;
Criminal sanctions;
Revocation of state business licenses and government contracts; and
Negative publicity.
Worksite enforcement has become increasingly aggressive over the past few years and there has been a noticeable shift from monetary fines to criminal prosecution of employers with unlawful hires and paperwork violations.
In view of the recent crackdowns by federal and state governments on immigration compliance, the steady stream of lawsuits being filed by affected employees, and the media hype surrounding immigration reform, it is critical for companies that hire foreign nationals to include potential immigration consequences of a corporate restructuring as part of the due diligence process.
Issues Affecting Nonimmigrant Visa Holders
In these situations it is important to determine whether the employer after a corporate restructuring is the same employer that filed the approved visa petition with the U.S. Citizenship and Immigration Services (USCIS) or Department of State (DOS). The consequences of a merger or acquisition depend upon the type of nonimmigrant visas that the company’s employees hold.
The most common temporary work visa is the H-1B visa, which is used by U.S. companies to temporarily hire foreign national workers for specialty occupations that require at least a bachelor’s degree or its equivalent to perform the job duties. H-1B workers are authorized to work for a specific company in a specific geographic location in a specific position and for a specific salary. Companies that hire an H-1B worker are required to make an attestation to the U.S. Department of Labor (DOL) that they will pay the worker a salary that meets or exceeds the prevailing wage for the listed occupation in the geographic area of intended employment for the duration of the employee’s status. This attestation is made in what is called a Labor Condition Application (LCA).
If an H-1B worker changes employers, the new employer must generally file a new H-1B petition with USCIS. However, if the new employer is a “successor-in-interest” to the previous employer, an amended petition may not be needed. USCIS requires an amended H-1B visa petition to be filed if there are any “material changes” in the terms and conditions of an H-1B worker’s employment or eligibility (for example, a major change in the employee’s job duties). However, USCIS does not automatically require the filing of a new LCA and amended H-1B petition where a new corporate entity succeeds to the interests and obligations of the original petitioning employer and where the terms and conditions of the employment remain the same but for the identity of the petitioner. In this situation, the new employer, called a successor-in-interest, must make available for public inspection a sworn statement that it accepts all the obligations and liabilities of the LCAs filed by the predecessor entity, a list of affected LCAs and their dates of certification by DOL, a description of the new entity’s actual wage system, and the federal employer identification number (EIN). The new entity must provide this sworn statement before the H-1B employees are transferred to the new employer. If, however, there is a material change in the terms of an H-1B worker’s employment as a result of a merger or acquisition, then a new LCA or amended H-1B petition may need to be filed. For example, if the new employer transfers an H-1B employee to another location, a new LCA may be required. In this case, the new LCA must be filed with DOL prior to the relocation of the employee in order to avoid filing an amended H-1B visa petition. Otherwise, if this issue is overlooked, an amended H-1B petition will need to be filed with USCIS, potentially costing the company thousands of dollars per employee.
One issue that often comes up in the situation of a successor-in-interest is when an H-1B employee needs to travel abroad. Generally, in order to reenter the United States, the employee must have a valid H-1B visa annotated with the petitioning employer’s name. However, in this case, the visa annotation would list the predecessor employer, which could cause the employee difficulty when trying to reenter the United States. In addition, a new visa may only be obtained when the successor employer files an extension or amended H-1B visa petition with USCIS, and that petition is subsequently approved on behalf of the employee. Collaboration with an experienced immigration attorney prior to finalizing the corporate reorganization can help prevent these issues from occurring, thereby minimizing the stress to employees and human resource specialists.
Another potential issue with regard to H-1B visas is whether a merger or acquisition results in the new entity becoming H-1B dependent. An employer is considered to be H-1B dependent if it has fewer than 25 full-time employees, more than 7 of whom are on H-1B visas; 26-50 full-time employees with more than 12 on H-1B visas; or more than 50 full-time employees where more than 15 percent are on H-1B visas. This is a critical determination to make because H-1B dependent employers are subject to additional compliance and attestation requirements. For example, prior to hiring an H-1B worker, an H-1B dependent employer must make a good faith effort to recruit U.S. workers for the offered position through advertising, job fairs, and other forms of industry-wide recruitment. Furthermore, the employer must offer the job to any equally or better qualified U.S. worker who applies for the position and must not favor current nonimmigrant employees who have not yet obtained H-1B status (such as students currently working pursuant to Optional Practical Training). Because of the arduous process that H-1B dependent employers have to go through prior to hiring a foreign national, most companies try to avoid becoming H-1B dependent at all costs.
Another visa category commonly affected by a corporate transaction is the L-1 temporary work visa. The L-1 visa is useful for multinational companies that wish to transfer managers, executives, and specialized knowledge employees to serve in similar positions at a qualifying organization in the United States. In order to qualify for an L-1 visa, the employee must have been employed for at least one year in the past three years by a foreign parent, subsidiary, affiliate, or branch of the U.S. company. Therefore, if the merger or acquisition of a company alters the organizational structure so that there is no longer a qualifying corporate relationship between the U.S. employer and the foreign entity, L-1 employees in the United States may lose their eligibility. It is important to note, however, that the foreign entity that actually employed the L-1 transferee does not have to remain in existence as long as there is another foreign entity that has a qualifying relationship with the U.S. employer. A merger or acquisition that does not destroy the qualifying relationship merely imposes an obligation upon the employer to notify USCIS of the change in the organizational structure at the time of filing a petition for the extension of the employee’s L-1 visa status. However, if the worker is moved to a different related entity, an amended L-1 petition may need to be filed with USCIS.
Mergers and acquisitions can also create qualifying relationships for purposes of the L-1 visa. In this situation, L-1 visa petitions may not be filed until the relationship has been formed, which usually involves the transfer of stock. An agreement to create a relationship is not sufficient to establish the qualifying relationship because it does not involve the necessary ownership and control.
A third visa category often used by multinational companies that could be affected by a corporate reorganization is the E visa category. The E-1 visa is used by citizens of countries with which the United States maintains a treaty of commerce and navigation who are coming to the United States to carry on substantial trade, principally between the United States and the treaty country (for example, an Israeli citizen who is coming to the United States to work for a company that imports security systems from Israel). The E-2 visa is used by citizens of countries with which the United States maintains a bilateral treaty who are coming to the United States to work for a company that is owned by nationals of the same treaty country as the employee (for example, a Swiss citizen coming to the United States to work for the Swiss cheese company, La Fromagerie).
In order for an E-1 or E-2 employee to work in the United States, the U.S. employer must qualify as a treaty company, either because a majority (more than 50 percent) of its trade is with the treaty country (E-1) or because it is at least 50-percent owned by nationals of the treaty country (E-2).
In the E-1 scenario above, if the U.S. company is acquired and the new employer continues to carry on a majority of its trade with Israel, then the Israeli E-1 employee may continue to work in the U.S. in E-1 visa status (although it is recommended that an amended E-1 petition be filed to reflect the change in corporate structure). However, if the new employer cannot show that more than 50 percent of its trade is with Israel, the E-1 employee will no longer qualify for E-1 visa status and will have to change to a different visa status.
In the E-2 scenario, the Swiss citizen may only obtain an E-2 visa if he or she works for a company in the United States that is at least 50 percent Swiss owned. Owners who are United States permanent residents or who are dual citizens of both the United States and the treaty country are treated as U.S. nationals for this purpose and their ownership interest is not counted toward the requirement for 50 percent ownership by treaty country nationals. Therefore, 50 percent ownership by the treaty country nationals must be maintained in any merger or acquisition; if the treaty company (La Fromagerie, in the example above) is acquired by a company that is not Swiss, E-2 employees will no longer meet the requirements for this category and will be forced to leave the United States if they are not eligible to apply for a different visa category.
Issues Affecting Pending Green Card Applications
The employment-based green card application process generally consists of three steps (see sidebar). In the case of pending green card applications, it is critical to first determine whether the new employer entity is considered a successor-in-interest. If not, the new employer will have to start the green card process over from the very beginning, potentially costing the company thousands of dollars in legal and filing fees and delaying the green card by several years. For purposes of the green card process, a new employer entity will be considered a successor-in-interest if (1) the job opportunity is the same as the job opportunity listed in the labor certification; (2) the new employer establishes its eligibility as a successor-in-interest in all respects, including providing evidence of the predecessor’s ability to pay the employee the offered wage as of the date of the filing of the Program Electronic Review Management (PERM) application; and (3) the new entity’s I-140 petition documents the transfer and assumption of the ownership of the predecessor entity.
In addition, an employee’s ability to continue with the permanent residence (green card) application depends on where in the process he or she is at the time of the corporate restructuring. If the labor certification is pending, it will remain valid as long as the new employer is a successor-in-interest to the employer that filed the original labor certification and there have been no changes in job position or location. Whether or not the new employer qualifies as a successor-in-interest is decided by USCIS at the time of the filing of the I-140 petition. Once the labor certification is approved by DOL, the new employer would then file the I-140 petition with USCIS along with evidence of the successor-in-interest relationship. However, if there are any changes in job position or location, or if the new employer does not qualify as a successor-in-interest, the pending labor certification will be invalidated and the new employer will have to file a new labor certification. This can have serious repercussions for employees who are relying on the pending labor certifications to continue extending their underlying nonimmigrant visa status. It will also delay the green card process significantly, especially for those employees concerned with priority dates due to immigrant visa backlogs.
If the I-140 petition is pending when the corporate restructuring occurs, but the adjustment of status application has not yet been filed, then the new employer will need to file an amended I-140 with USCIS showing that the requisite successor-in-interest relationship exists. The same is true if the I-140 has been approved but no adjustment of status application has been filed yet.
The best scenario for both the new employer and foreign national employees in the middle of the green card process is an approved I-140 and a pending adjustment of status application. This is because the American Competitiveness in the 21st Century Act (AC21) allows a foreign national to change employers if the I-140 has been approved and the adjustment of status application has been pending for 180 days or more, as long as the new position is in the “same or similar occupational classification.” In determining whether a new position is the “same or similar” as the position on the approved labor certification, USCIS looks at several factors including the job descriptions of both positions, the salaries, and the DOL’s Dictionary of Occupational Titles (DOT) and/or Standard Occupational Classification (SOC) codes for each position. While there is no requirement to notify USCIS of a change in employer with respect to a pending adjustment of status application, many attorneys recommend proactively notifying USCIS of the change in employer and showing that the new position is the “same or similar.”
Multinational managers and executive transferees (see L-1 visas above) do not have to go through the arduous labor certification process when applying for a green card. However, because their eligibility for permanent residence hinges upon the relationship between the foreign employer and the U.S. employer, a corporate restructuring can have negative consequences on these employees’ eligibility to qualify for permanent residence in this category.
When the U.S. company and the foreign company are affiliated through the ownership of a group of individuals, mergers and acquisitions become an issue because each group of individuals must own and control each business and each individual in the group must hold approximately the same proportion of each business (or the same shareholders must have a controlling interest in each business). Additionally, the U.S. employer must have been doing business in the United States for at least one year to be able to file this type of petition on behalf of one of its employees. Interestingly, there is no requirement that a qualifying relationship exist between the United States and the foreign entities for the one-year period, so a U.S. entity acquired by a foreign entity may immediately apply for an otherwise qualifying manager or executive. However, the foreign entity that actually employed the transferee must continue to exist in order to file an immigrant visa petition on behalf of a multinational manager or executive.
I-9 Compliance
One of the most important (but overlooked) issues that an employer should be concerned with at the time of a restructuring is the Form I-9. The Immigration Control and Reform Act of 1986 requires that a Form I-9 (Employment Eligibility Verification) be completed for each newly-hired employee, with some exceptions. A successor-in-interest may assume the I-9 liabilities of the predecessor employee; however, this means that the new employer is also liable for any mistakes in the I-9s previously completed by the predecessor. Therefore, before a transaction is undertaken, an examination of the organization’s I-9s should be conducted through either an audit or a review. If the successor organization does not assume I-9s of the predecessor, new I-9s may be completed for each of the organization’s employees within three days of the transaction to avoid any allegation of an unfair immigration-related employment practice such as document abuse or discrimination on the basis of citizenship or nationality.
Conclusion
It is critical for in-house counsel to be aware of immigration-related issues that may arise as a result of a restructuring between companies that employ foreign nationals. Companies should work with competent and experienced immigration counsel early on in any transaction to ensure that they are in compliance with immigration regulations and to ensure that foreign national employees remain authorized to work in the United States.
On January 20, 2013, the Consumer Financial Protection Bureau (Bureau) released its final rule regarding the loan originator compensation requirements under the Truth in Lending Act (Rule). It followed up by publishing the Rule in the Federal Register on February 15, 2013. Despite the Bureau’s labeling of the Rule, it does more than implement statutorily required loan originator compensation changes. It also clarifies existing loan origination compensation requirements, including those based on prior informal interpretations rather than the plain language of Regulation Z or its commentary. Less obvious from the name of the Rule, it includes loan originator qualification requirements, requires the use of unique identifiers on certain loan documents, prohibits mandatory arbitration provisions and the financing of single-premium credit insurance for covered loans, and extends record keeping requirements. It also addresses the statutory prohibition on upfront points and fees in certain loans. The provisions regarding mandatory arbitration and the financing of single premium credit insurance have a stated effective date of June 1, 2013. The remainder of the Rule has a stated effective date of January 10, 2014.
The Rule revises the definition of the term “loan originator.” The term generally will mean a person, who in the expectation of compensation, does any of the following in connection with a residential mortgage loan: offers, arranges, negotiates, takes an application for, assists a consumer in obtaining or applying for, or otherwise obtains or makes a residential mortgage loan for another person. It will also include a person that advertises that the person can or will perform any of these activities. The Bureau will interpret this definition broadly and, consistent with prior informal interpretations, will include referral activity within the scope of covered loan origination activities. However, the Rule and related commentary provide some clarifications regarding the scope of covered referral activity. For example, covered referral activity will not include, among other things, providing general information in response to inquiries or, if the person is an employee of a creditor or mortgage broker, providing contact information for a loan originator in response to a request, unless the employee does so based on the inquiring person’s financial characteristics or discusses particular loan terms. Additionally, the Rule lists several categories of persons that will not be loan originators, including certain bona fide third-party advisors, certain licensed or registered real estate brokers, certain seller financers, and loan servicers and their employees when modifying or offering to modify an existing loan that is in default or is likely to go into default. It also clarifies when administrative and clerical staff members are not acting as loan originators.
The Rule continues the prohibition on basing loan originator compensation on any of the residential mortgage loan transaction’s terms or conditions, including any factor that is a proxy for a loan term or condition. The terms and conditions will include any right or obligation of the parties to a residential mortgage loan, except the amount of credit extended if the compensation is based on a fixed percentage. The Rule provides clarification regarding what constitutes a proxy. A factor will be a proxy if it consistently varies a term or terms over a significant number of loans and the loan originator has the ability to add, drop, or change the factor.
Consistent with prior informal interpretations of Regulation Z, the Rule clarifies that the prohibition includes not only compensation based on the terms or conditions of a single transaction, but also compensation based on the terms of multiple transactions by a single loan originator or multiple loan originators. Because the prohibition includes the terms or conditions of multiple loans by multiple originators, loan originator compensation cannot be based on the profits of a residential mortgage loan-related business. The Rule adopts this interpretation, but creates two exceptions. First, contributions to or benefits paid from designated tax-advantaged plans are permissible if they are not based on the terms of the individual loan originator’s transactions. Second, payments pursuant to certain non-deferred profits based compensation plans, as set forth in the Rule, could be permissible if they meet additional requirements, such as being limited to 10 percent or less of the loan originator’s total compensation or if the individual was the loan originator for 10 or fewer residential mortgage loans during the 12 months preceding the compensation determination date.
The Rule, similar to current Regulation Z, will generally prohibit reductions to loan originator compensation to offset costs if the terms of a transaction change. The reductions are prohibited because they are based on a term or condition of the transaction. However, the Commentary to the Rule states that reductions to compensation to offset unanticipated increases in certain settlement charges are permitted.
The Rule creates an exception to the Regulation Z prohibition on dual compensation. The Rule will allow a mortgage broker that receives compensation from the consumer to pay its employees or contractors commissions under certain circumstances.
For some, what is not in the Rule may be as important as what is in it. The Dodd-Frank Act would have prohibited certain loan originator compensation if the borrower paid upfront points and fees. For example, the Dodd-Frank Act would have generally prohibited a lender from paying individual loan originators certain commissions and other compensation in connection with a mortgage loan if the borrower paid up front points and fees. The Bureau had proposed creating a partial exemption. The proposal would have allowed a lender to charge up front points and fees and pay commissions and other compensation if the lender offered the borrower an alternative loan that did not include upfront points and fees. Rather than adopt this partial exemption, the Bureau decided to adopt a complete exemption to the statutory ban on upfront points and fees. The Bureau intends to assess the effects of the complete exemption and may take future action, including narrowing the exemption.
The Rule imposes obligations on creditors and mortgage brokers to ensure that the individual loan originators who work for them (i.e., employees, agents, contractors) are licensed or registered under other applicable laws, such as the Secure and Fair Enforcement for Mortgage Licensing Act of 2008. The Rule requires creditors and mortgage brokers that employ individual loan originators who are not required to be licensed or registered to ensure that these loan originator employees meet character, fitness, and background standards and receive training similar to licensed and registered loan originators. The Rule also requires that creditors and mortgage brokers include their unique identifiers and names on certain loan documents. The creditor or broker also must list the name and identifier of the individual loan originator primarily responsible for the origination of the loan.
The Rule prohibits loan terms that require the borrower to submit a dispute about a residential mortgage loan or certain home equity lines of credit (HELOCs) to binding arbitration. Additionally, under the Rule, no agreement relating to a residential mortgage loan or certain HELOCs could be applied to bar a borrower from bringing a court claim regarding an alleged violation of federal law. However, the parties could agree to arbitrate or otherwise settle a claim after a dispute arises.
The Rule prohibits the financing of any premiums for credit insurance in connection with a residential mortgage loan or certain HELOCs, but will permit premiums that are calculated and paid in full on a monthly basis.
The Rule expands recordkeeping requirements regarding loan originator compensation. The recordkeeping requirements apply to loan originator organizations, including both creditors and mortgage brokers. They will be required to keep evidence of compliance for three years. The increased time period will match the longer statute of limitations that will apply to claims for violations of the loan originator compensation requirements.
In conclusion, the Rule could affect several different aspects of a mortgage lender’s or broker’s operations, including hiring, employee training, compensation structures, referral activities, loan forms, litigation budgets, record retention schedules, and other policies and procedures. Going forward, lenders and brokers may be able to revise compensation structures. If they do so, they may need to consider other recently published rules that could affect loan originator compensation (e.g., Ability-to-Repay Rule). Depository institutions will have to provide additional training and background screening. Lenders and brokers will likely need to revise loan documents to provide identification information and revise their record retention schedules and other policies and procedures so that they are able to demonstrate compliance. The Rule is an example of the importance of reviewing not only the regulation but also the commentary and supplementary information. In this case, the Rule does not cover everything that one must know about upcoming loan originator compensation issues, but the commentary and supplementary information as well as the regulation clarify several important points from current Regulation Z’s requirements and cover several other issues on which mortgage lenders and brokers will need to be advised.
On January 10, 2013, the Bureau of Consumer Financial Protection (Bureau) issued a final rule amending Regulation Z by expanding the types of transactions subject to the Home Ownership and Equity Protection Act of 1994 (HOEPA), revising and expanding HOEPA thresholds, and imposing additional requirements on HOEPA loans. The final rule also amends Regulation Z and Regulation X (RESPA) by imposing homeownership counseling requirements. These changes are effective for all loans applied for on and after January 10, 2014.
This article focuses on the final rule’s expanded coverage, thresholds, requirements, and its impact on creditors, brokers, purchasers, and consumers.
Expanded Coverage
Transactions eligible for HOEPA coverage now include purchase-money loans and home-equity lines of credit (HELOCs). Transactions excluded from coverage include: reverse mortgage loans, loans to finance the initial construction of a dwelling, loans originated by a Housing Finance Agency, and loans under USDA’s Section 502 Direct Loan Program. While this expanded coverage may improve consumers’ understanding of the terms and features of a high-cost mortgage, it also may limit their access to credit, since most lenders are reluctant to make high-cost mortgages. Further, creditors will incur additional costs in identifying these types of loans, including, but not limited to, those costs related to changing or upgrading automated systems and disclosures, legal and compliance review, and staff training. Creditors also may lose revenue as a greater number of their loans are subject to HOEPA, and there is limited secondary market demand for high-cost mortgages.
What is a High-Cost Mortgage?
A “High-Cost Mortgage” is a consumer credit transaction secured by a consumer’s 1-4 unit principal dwelling, including purchase and non-purchase money closed-end credit transactions and HELOCs, in which
The annual percentage rate (APR) exceeds the average prime offer rate (APOR) for a comparable transaction by more than:
6.5 percentage points for first liens;
8.5 percentage points for first liens less than $50,000 secured by a dwelling that is personal property (e.g., manufactured home); or
8.5 percentage points for junior liens;
The total points and fees exceed:
5 percent of the total loan amount if the loan amount is $20,000 or more; or
The lesser of 8 percent of the total loan amount or $1,000 for a loan amount less than $20,000 (the $1,000 and $20,000 figures are adjusted annually); or
A prepayment penalty may be charged more than 36 months after consummation or account opening, or may exceed, in total, more than 2 percent of the amount prepaid.
Although the thresholds seem straight-forward, the devil is in the details. Let’s dive into those details.
New High-Cost APR and Index
Creditors may use one of three methods to determine the interest rate for the APR calculation. For a fixed-rate transaction, a creditor must use the interest rate in effect as of the date the interest rate for the transaction was set. For a variable-rate transaction which varies according to an index, a creditor must use the higher of the index plus margin or the introductory interest rate in effect as of the date the interest rate for the transaction is set. For a variable-rate transaction which does not vary according to an index (e.g., step-rate mortgage), a creditor must use the maximum interest rate that may be imposed during the term of the transaction.
In order to determine the applicable rate threshold, a creditor must now use the APOR index for a comparable transaction. APOR tables and guidance are available at www.ffiec.gov/ratespread/aportables.htm and www.ffiec.gov/ratespread. There are three factors to consider when determining a “comparable transaction”: (1) whether the transaction is a fixed-rate or variable-rate, (2) the date the interest rate for the transaction was set, and (3) the term of the transaction. The “date the interest rate was set” means the date on which the loan’s interest rate is set for the final time before closing. If there is a rate lock agreement, it is the lock date specified in the agreement. If a rate is reset after execution of a rate lock agreement (e.g., float-down option exercise date), then the relevant date is the date the rate is re-set for the final time before closing. If there is no rate lock agreement, the relevant date is the date on which the rate is set for the final time before closing. In the case of a fixed-rate transaction, the “term of the transaction” is the transaction’s term to maturity. In the case of a variable-rate transaction, the “term of the transaction” is the initial fixed-rate period, rounded to the nearest number of whole years (or, if the initial fixed-rate period is less than one year, one year). A creditor originating a fixed-rate, evergreen HELOC should use a term of 30 years.
What is the potential impact of the revised APR threshold? First, the Bureau estimates a 20 percent increase in refinance and home improvement loans that will be High-Cost Mortgages. Second, FHA recently extended its monthly mortgage insurance premium requirement. This will cause the APR for FHA loans to be higher, since the APR reflects costs other than interest on closed-end transactions, which in turn could make more FHA loans High-Cost Mortgages. Third, the APR calculated from a fully-indexed rate will be higher than the composite APR calculated according to Regulation Z Section 1026.17.
New High-Cost Points and Fees Threshold and Definition
Which points and fees threshold applies depends on whether the face amount of the note, in a closed-end transaction, or the credit limit, in an open-end transaction, is $20,000 or more. In contrast, for the points and fees threshold calculation, the final rule uses a “total loan amount.” In a closed-end transaction the “total loan amount” is calculated by starting with the amount financed and subtracting (1) any financed item listed in 1026.4(c)(7) which is unreasonable or is paid to the creditor or an affiliate; (2) any upfront financed credit insurance premium; and (3) the prior loan’s prepayment penalty if it is financed, subject to certain limitations. The HELOC “total loan amount” is the credit limit.
The final rule also amends the definition of points and fees to remove certain items previously included (e.g., certain upfront mortgage insurance premiums and bona fide discount points) and to add other items (e.g., the maximum prepayment penalty). Under the final rule, “points and fees” mean the following fees or charges that are known at or before consummation:
All items included in the finance charge under 1026.4(a) and (b).
All compensation paid directly or indirectly by a consumer or creditor to a loan originator that can be attributed to the transaction at the time the interest rate is set. This requirement, as currently drafted, would double-count loan originator compensation under certain circumstances. There is a Concurrent Proposal that would address this issue. Stay tuned.
All items listed in 1026.4(c)(7) if unreasonable, or the creditor or its affiliate receives compensation, direct or indirect, in connection with the charge.
The maximum prepayment penalty. (Note: The following state high cost points and fees calculations also may include some or all of the prepayment penalty amount: Arkansas, Georgia, Massachusetts, New Jersey, New Mexico, North Carolina, and South Carolina.)
The prior loan’s prepayment penalty, subject to certain limitations. (Note: Georgia, Massachusetts, New Jersey, and New Mexico have a similar requirement.)
For HELOCs only, any participation fee payable at or before account opening and any minimum or per-transaction fee (assume at least one draw).
The following items known at or before consummation are excluded from the calculation of “points and fees”:
Interest or time-price differential
Any premium or similar charge imposed in connection with a federal or state agency program (i.e., FHA Mortgage Insurance, VA Funding Fee, or USDA RHS Upfront Guarantee Fee).
Any premium or similar charge that protects the creditor against the consumer’s default or other credit loss (e.g., private mortgage insurance), but only to the extent the upfront amount does not exceed the FHA upfront mortgage insurance premium for a comparable loan and the upfront guarantee or premium is automatically refundable on a pro rata basis upon satisfaction of the mortgage.
Any bona fide third-party charge not retained by the creditor, loan originator, or an affiliate of either, unless the charge is required to be included;
Up to 2 bona fide discount points, if the undiscounted interest rate does not exceed the comparable APOR by more than 1 percentage point, or up to 1 bona fide discount point if the undiscounted interest rate does not exceed the APOR by more than 2 percentage points. For transactions secured by personal property, a creditor would use the average rate for a loan insured under Title I of NHA. A discount point is considered bona fide if it reduces the undiscounted rate by at least .25 basis points. (The following states have some form of bona fide discount point exclusion in their high cost thresholds: Indiana, New Jersey, New Mexico, North Carolina, South Carolina, and Tennessee.)
Based upon the lower points and fees threshold, smaller loan amounts may easily exceed the 5 percent threshold. If this occurs, access to small loan credit may be limited, as creditors and the secondary market have little appetite for High-Cost Mortgages.
New Prepayment Penalty Threshold
The new threshold limits when a penalty may be imposed to the first 36 months of the transaction, and limits the penalty amount to 2 percent of the amount prepaid. For purposes of this threshold, a prepayment penalty does not include (1) certain conditionally-waived upfront bona fide third-party closing costs; and (2) until January 21, 2015, interest charged consistent with the monthly interest accrual amortization method for FHA insured transactions.
The Bureau believes the number of transactions affected by the prepayment threshold will be small, since the maximum prepayment penalty is included in the points and fees calculation, and a creditor would have to forgo some or all of the other charges included in the points and fees calculation, in order to originate a “qualified mortgage” which caps points and fees at 3 percent. In addition, limiting the penalty to the first 36 months will impact lenders in California, Louisiana, Minnesota, New Hampshire, and Ohio, all of which allow prepayment penalties to be charged for a longer period (60/84, 60, 42, 60, and 60 months respectively). This threshold also impacts the allowable prepayment penalty amount in Illinois, 3 percent, and Louisiana, which allows a 5 percent penalty in the first year.
New High-Cost Mortgage Restrictions
Sections 1026.32 and 1026.34 provide that once a transaction is a High-Cost Mortgage:
Balloon payments are generally prohibited.
Prepayment penalties are prohibited.
Financing points and fees are prohibited.
Late fees cannot exceed 4 percent of the past due payment or be imposed until after 15 days past due.
Payoff statement must be provided within 5 days of request and fees are restricted.
Modification and Deferral Fees are prohibited.
Ability-to-Repay assessment is required for HELOCs. Closed-end loans must meet the 2013 Ability-to-Repay Final Rule requirements.
No default may be recommended or encouraged.
Revised High-Cost Mortgage Disclosures
Section 1026.32(c) revises the High-Cost Mortgage disclosure and distinguishes closed-end and HELOC requirements. A creditor must provide the disclosure to the consumer not less than 3 business days prior to consummation or account opening. “Business day” has the same meaning as the Regulation Z rescission rule. If the disclosure becomes inaccurate, a creditor must provide new disclosures and begin a new 3-day waiting period. A consumer may waive the waiting period to meet a bona fide personal emergency. A creditor may provide new disclosures by telephone if the consumer initiates the change and if, prior to or at consummation or account opening (1) the creditor provides new disclosures, and (2) the consumer and creditor sign a statement concerning the delivery and timing of telephone disclosures.
Corrections of Unintentional Violations
New Section 1026.32(h) allows a creditor or assignee, who, when acting in good faith, fails to comply with any Section 1026.32 requirement, to take steps to cure the “violation” by providing written notice of available choices. For notice to be adequate, the consumer should have at least 60 days to consider the options and communicate a choice. The creditor or assignee must satisfy either of the following sets of conditions:
Within 30 days of consummation or account opening and prior to the institution of any action, the consumer discovers the violation or the creditor or assignee notifies the consumer, and the creditor or assignee (a) provides appropriate restitution within 30 days; (b) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) Changing the transaction’s terms so it will no longer be a High-Cost Mortgage.
Within 60 days of the creditor’s discovery or receipt of notification of an unintentional violation or bona fide error and prior to the institution of any action, the creditor (a) notifies the consumer of the compliance failure; (b) provides appropriate restitution within 30 days; and (c) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) changing the transaction’s terms so it will no longer be a High-Cost Mortgage.
Regulation X (RESPA) Homeownership Counseling Organization List
12 CFR 1026.20 requires a lender to provide a written list of homeownership counseling organizations (the List) to the applicant of a federally related mortgage loan, which includes a loan (other than temporary financing, e.g., construction loan) secured by a 1-4 unit dwelling, including purchase and non-purchase money closed-end credit and HELOCs. The creditor must retrieve the List information from the Bureau’s website or from data made available by the Bureau or HUD no more than 30 days prior to delivery.
A lender must provide the List no later than 3 business days after the lender or mortgage broker receives an application. If there is more than one applicant, the lender may provide the List to the applicant with primary liability. If the lender does not provide the List in person, the lender must mail or deliver it by other means, including electronically, subject to the E-Sign Act. Although the lender is ultimately responsible for compliance, a mortgage broker or dealer also may provide the List. If there is more than one lender, only one List is required. Unless otherwise prohibited, the lender may provide the List with other required disclosures. For a HELOC subject to Regulation Z, a lender that provides the applicant with the List may comply with the timing and delivery requirements of either 1024.20(a) or 1026.40(b).
A lender does not need to provide the List if before the end of the 3 business days, the application is denied or withdrawn, or the application is for a reverse mortgage or loan secured by a timeshare.
High-Cost Mortgage Counseling Requirements
Section 1026.34(a)(5) requires a creditor, prior to making a High-Cost Mortgage, to receive written certification from an unaffiliated HUD-certified or -approved or state housing finance authority-certified or -approved counselor that the consumer received counseling on the advisability of the transaction. The certification must contain the elements specified in 1026.34(a)(5). The creditor may receive the certification by mail, e-mail, or facsimile. A creditor may process the application, order the appraisal or title search, prior to receiving the certification.
A consumer may not obtain counseling until after receiving the initial good faith estimate on a closed-end transaction or the initial HELOC disclosures required by Regulation Z. A creditor cannot direct a consumer to a particular counselor or organization. A consumer may pay a bona fide third-party counseling fee and it may be financed. A creditor may pay the fee, but cannot condition payment on loan consummation or account opening. A creditor may confirm counseling prior to paying the fee; however, if the consumer withdraws the application, a creditor may not condition the payment on receipt of the certification.
Negative Amortization Counseling Requirements
Section 1026.36(k) requires a creditor, prior to making a closed-end loan secured by a 1-4 unit dwelling which may result in negative amortization, to obtain confirmation that a first-time borrower received counseling on the risks of negative amortization from a HUD-certified or -approved counselor or counseling organization. Acceptable confirmation includes a certificate, letter, or e-mail. This requirement does not apply to reverse mortgages or loans secured by a timeshare. A creditor cannot direct a consumer to choose a particular counselor or organization. Although a creditor cannot make the loan prior to receiving this confirmation, a creditor may engage in other activities, such as processing the application or ordering the appraisal or title search.
Conclusion
Although originations of High-Cost Mortgages are a small percentage of the market as a result of special disclosure requirements, restrictions, enhanced borrower remedies, and assignee liability, the expansion of HOEPA coverage will increase the number of loans subject to HOEPA and the new and lower thresholds will increase the number of loans classified as High-Cost Mortgages. What percentage of loans this will include is difficult to determine.
This article just begins to scratch the surface of the issues this final rule raises for lenders, brokers, and their compliance or legal experts. Lenders will want to review 30 state and local high cost coverage and threshold requirements to determine any necessary changes. Lenders will want to review rates and fees on smaller loans, in order to determine how to price these loans appropriately to avoid a High-Cost Mortgage designation. Lenders and brokers will want to review their loan originator compensation policies. Lenders will want to review state prepayment penalty riders to ensure compliance with federal and state law. Lenders will want to consider creating new procedures to handle unintentional Section 32 violations, to meet the timing and other cure requirements. Finally, lenders will need to plan for the additional costs they will incur in updating automated systems, disclosures and documents, employee training, and outside legal advice. Will these HOEPA changes ultimately help consumers or reduce access to credit? Only time will tell.
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