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To protect their mortgages, lenders frequently require borrowers to escrow real estate tax payments and insurance premiums, particularly in connection with home mortgage loans. According to a recent case, failure to properly manage those escrows could get lenders into trouble. Smith v. GMAC Mortgage Corp., 2007 WL 2593148 (W.D.N.C. 9/5/07). In that case, Smith sought a declaratory judgment and injunction on behalf of a putative class of home borrowers for the mismanagement of the insurance escrow. The mortgage required hazard and property insurance and stated that if the borrower failed to maintain coverage, the lender at its option could place insurance to protect the lender’s rights in the property. Insurance obtained by the lender under those circumstances is referred to as “force-placed insurance.” Canceled Insurance Smith had been paying premium installments into an escrow account, and GMAC had been making payments to Nationwide Insurance Company for homeowner’s insurance premiums. The policy was “mortgage billed.” Therefore, Nationwide had sent bills for the insurance premiums to GMAC, not Smith. Even though Smith continued to make the customary payments into escrow, apparently GMAC had not paid the bills even after Nationwide had sent a series of notices to GMAC that their insurance premiums had not been paid and that the policy would be cancelled for non-payment. Ultimately, a Nationwide agent sent a notice to GMAC that the insurance had been canceled and that Smith had lost the advantage of earlier eligibility rules, so that if she renewed her insurance, the premium would he recomputed under new guidelines. Later, GMAC denied that it had failed to pay the insurance premiums, and blamed the problem on Nationwide. But GMAC apparently never denied that it failed to respond to Nationwide’s notices that the policy was about to lapse for non-payment. Unfortunately, Smith apparently received no word of the problem until after the policy had lapsed. That is when GMAC finally sprung into action. It then sent notice to Smith that it would force-place an insurance policy through The Balboa Insurance Group. That policy cost three times the amount of the Nationwide policy. Smith alleged that the increased burden of this policy caused her to default on her mortgage payments that led GMAC to schedule a foreclosure, which a judge finally dismissed. In addition to these problems, Smith’s credit rating deteriorated, causing other credit problems, and Smith alleged that GMAC also failed to pay the property taxes on her home, although it had received the escrowed tax payments. She finally was able to place another Nationwide insurance policy, but due to the re-rating, her premiums had increased by 70 percent. To make matters worse for GMAC, the footnotes in the decision explained that GMAC had used Balboa to administer the escrow accounts. Also, GMAC allegedly received a commission or other compensation when implementing the Balboa force-placed insurance policy on Smith. In addition to all of this, Smith challenged GMAC’s practice of outsourcing its duties to manage escrow accounts without instituting proper oversight. Fiduciary Duties In her lawsuit, Smith predicated her claim on the theory that GMAC had a fiduciary responsibility to her as manager of an escrow account, and GMAC moved for a summary judgment on the grounds that a lender could not be regarded as a fiduciary of a borrower. The federal district court in North Carolina ruled that under North Carolina law, the answer to that issue depends on an analysis of all the facts and circumstances. It then ruled that Smith had made a sufficient showing to support denial of summary judgment. It found that the existence of a fiduciary relationship between a mortgagor and lender is a question that neither the Supreme Court of North Carolina nor the 4th U.S. Circuit Court of Appeals has directly addressed; consequently, it is one of first impression for that court. After reviewing the relevant cases, the court held that a fiduciary relationship could be found where “special circumstances” existed resulting in one party having “superiority and influence” over the other. Also, the court discussed relationships in which a subordinate party entrusted the handling of its business affairs to the dominant party and placed trust and confidence in it. It suggested that North Carolina already had concluded that a mortgage lender had a fiduciary relationship with a borrower concerning transactions affecting the mortgage property. According to the court, this was particularly true in a residential transaction where the homeowner entrusts to the lender the responsibility for paying taxes and insurance with money provided by the homeowner. However, the court concluded that the ultimate determination of whether there was a fiduciary duty would have to be decided by a jury. In reaching its conclusion, the court stated: “Because GMAC was exclusively responsible for attending to the payment of insurance premiums (through a third-party servicing agent or otherwise), and because Plaintiffs’ homeowners’ insurance was ‘mortgagee billed,’ a reasonable juror could determine that GMAC possessed sufficient control, direction, and influence over Plaintiff’s interest.” The court also found: “The facts of the instant case aptly illustrate the steep consequences attendant to non-payment of taxes and insurance to the homeowner and the rationale for the mortgagee to allocate to itself the duty of faithful payment of property taxes and insurance premiums. The mortgagor places trust and confidence in the mortgagee’s assumption of this responsibility and justifies a finding that Count three of the Complaint remains viable. This almost universal practice reflects the significant bargaining power of mortgagees over that of mortgagors. The level of confidence that a mortgagor (servient party) instills in the mortgagee is significant under these circumstances. When there is a cognizable level of confidence between two parties, both are ‘bound to act in good faith and with due regard to the interests of the one reposing confidence.’” Implications The Smithcase has broad implications for both lenders and borrowers. While it is not clear that the fiduciary duties would apply equally to commercial loans, that concept would raise the bar for lenders in handling customary mortgage escrows. They will have to pay special attention to avoiding defaults that could trigger termination of insurance policies, or a tax sale for failure to pay real estate taxes in a timely manner. Think about what would happen if a policy were terminated and a fire should occur. It is particularly important that lenders protect themselves with special casualty insurance applying to all of their mortgaged properties to cover just such errors or omissions. Also, a fiduciary obligation would give the lender a duty to avoid profiting in any way from the placement of insurance or from making forced-placement decisions that were not in the best interests of the borrower. For example, does the lender have a duty to shop around to find the lowest priced comparable insurance? Do lenders generally have written policies and procedures in place that deal with these objectives? The failure to make timely real estate tax payments when dealing with thousands of real estate tax bills has other implications. In one matter this author had undertaken for a client, the lender discovered an employee in its escrow-processing group simply became overwhelmed and tossed the tax bills into the trash without ever paying them. As a result, homeowners received bills from municipalities with interest and penalties added and threats of tax sales, even though they had paid their required tax installments to the lender. Again, it would be advisable for those lenders to protect themselves with adequate liability insurance for such contingencies. Also, if that disaster ever occurs they had better engage a first-class public relations adviser for damage control. In the Smithcase, it is not completely clear when Smith discovered she had a problem and what she did to correct it, but once a borrower finds out about these problems she should move quickly to act on that information even if she knows that she is up-to-date in her escrow payments. Such a borrower may find that the law imposes some duty to do what she can to mitigate the potential damages. One of the issues raised in the Smithcase is whether lenders who escrow premiums and taxes can protect themselves in other ways. For example, should such lenders require insurance companies to send notices of billings to both the lender and the homeowner and should they require that an acknowledgement of payment be sent to each? Is there anything that can help such lenders to disclaim liability for the management of these accounts? Would it make any difference if language in the mortgage states that the lender was not acting in a “fiduciary capacity,” was acting only as an agent for the homeowner and that ultimately it was up to the homeowner to make sure that the insurance policy did not expire? Suppose at closings those provisions were set forth in a separate notice in large print which was acknowledged by the homeowner? In most situations those tactics would probably make no difference under circumstances where the lenders clearly avoided carrying out their expected duties. However, it is possible that under certain conditions those provisions might prove to be of some help to them. In summary, lenders frequently establish policies of requiring mortgage escrow accounts without fully appreciating their potential exposure to individual liability, and even possible class actions for their conduct. The Smithcase serves as a warning that administering insurance premiums and real estate tax bills may bring on desired mortgage protection, but it also carries substantial responsibilities. Harris Ominsky is with the law firm of Blank Rome and is a former president of the board of the Pennsylvania Bar Institute.

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