In the case of In re Stewart, the U.S. Bankruptcy Court for the Eastern District of Louisiana held that the conduct of the debtor's mortgagee, Wells Fargo Home Mortgage Inc., was "duplicitous and misleading," and assessed damages of $27,350 against Wells Fargo. The court found that Wells Fargo had improperly charged the debtor for services, overcharged the debtor based on incorrect calculations of escrowed funds and submitted an adequate protection order containing undisclosed and unapproved fees. Based on a perception that these problems were systemic, the bankruptcy court also ordered Wells Fargo to audit and amend every proof of claim in cases pending in that court, and to provide a complete loan history on every account for which Wells Fargo had filed a claim. With respect to closed cases in which Wells Fargo had filed a proof of claim after March 2007, the court ordered Wells Fargo to prepare and deliver copies of an accounting to the trustee, the debtor and the debtor's counsel.

The Facts

In 1999, Dorothy Stewart and her husband obtained a loan from Northwest Mortgage Inc. evidenced by a promissory note and secured by a mortgage on their home. In turn, Northwest entered into a contract with Wells Fargo pursuant to which Wells Fargo was to service the mortgage. The promissory note provided for, among other things, a late charge in the amount of 5 percent of the past due installment and reimbursement of up to 25 percent of the note balance for attorney fees. The mortgage provided the same reimbursement of attorney fees and allowed Wells Fargo to make reasonable inspections of the property after providing notice to the mortgagors, which notice was to include Wells Fargo's reason for the inspection. Pursuant to the mortgage, Wells Fargo was also authorized to collect monthly the amounts estimated to cover property tax or insurance and, in the event of failure of the mortgagors to make payments, to pay all necessary costs to protect the property value and add these costs to the debt secured by the mortgage. Finally, the mortgage established an order of priority in applying payments: first to prepayment charges; next to property taxes or insurance premiums; next to accrued interest; next to accrued principal; and finally, to late charges.

On June 12, 2007, Dorothy Stewart filed a petition for relief under Chapter 13 of the Bankruptcy Code. Two earlier petitions (one filed individually by the debtor's husband) were dismissed on account of the debtor having failed to make payments to the trustee. One month after the petition date, Wells Fargo filed its proof of claim in the amount of $33,641.80 signed by its national counsel. It subsequently amended the proof of claim twice to increase the amount set forth in the claim and to modify language in the claim relating to anticipated fees and costs in the bankruptcy case.

On Aug. 23, 2007, the debtor filed an objection to the second amended claim of Wells Fargo, asserting that Wells Fargo abused its discretion in imposing fees, costs and charges, and requesting a payment history and support for several items listed as "Other Amounts for Inspection Fees, Appraisal Fees, NSF Check Charges, and Other Charges, Pre-Petition Attorney Fees and Costs" and "Escrow Advance." Wells Fargo, through its local counsel, filed a response in which it further itemized several of the charges without supplying information as to the amount, date, or payee for each charge, or proof of payment for amounts that it had advanced.

The hearing on the debtor's objection was held Sept. 25, 2007. Neither national counsel, who signed the proof of claim, nor local counsel, who filed a response to the objection, was present at the hearing. Instead, two attorneys, from the third and fourth law firms to represent Wells Fargo in the matter, attended. These local counsel were uninformed as to the substance of the claims except with regard to an error in billing for an eviction suit that had been dismissed. The court continued the hearing to Nov. 1, 2007, and ordered the appearance of the national counsel of Wells Fargo and the local counsel who had signed the response to the debtor's objection.

At the hearing in November, the court considered Wells Fargo's request for an extension of the deadline to produce documentation and for an accounting. In granting the extension, the bankruptcy court ordered Wells Fargo to provide documentation on the foreclosure charges and any other charges against the debtor's account, together with any notices delivered to the debtor concerning interest rate changes. In addition, the court requested that Wells Fargo send a representative with personal knowledge of the loan and administrative policies of Wells Fargo.

On Dec. 4, 2007, the court presided over a hearing in which national and local counsel to Wells Fargo, as well as the company's vice president in charge of the bankruptcy department, were present.

Analysis of the Court

The court found that Wells Fargo's admission of errors in its proof of claim at the first hearing was sufficient to rebut the prima facie presumption of the validity of Wells Fargo's claim and to shift the burden to Wells Fargo.

Next, the court noted that the securitization of home mortgages created an environment where non-traditional lenders operate and the interests of the note holder may be different than those of the note servicer. For example, the note holder relies on collection of payments and their application to principal and interest, while the note servicer typically benefits through the collection of fees and the holding of funds that generate additional income for the servicer.

The court also commented on the computerized system that Wells Fargo and other service providers used to manage their accounts. The software programs controlled most aspects of a mortgagor's account, including billing, assessing charges, initiating work orders for property inspections and sending demand letters. The court noted that it was the internal logic of the software program — and not an account officer — which decided what action should be taken and when it should be taken. In fact, Wells Fargo's computer system, on its own initiative, automatically contacted national counsel when it determined legal action was necessary, compiled a database of related files, and granted counsel access to the information. Typically, local counsel received all its information from national counsel and did not have access to files or account history. National counsel prepared the proofs of claim, while local counsel actually filed the pleadings and made court appearances. Wells Fargo, on the other hand, was absent in these endeavors and admittedly only reviewed the proof of claim after it was filed.

The court noted that it had twice previously scrutinized Wells Fargo's loan administration practices in other cases. Those cases revealed several errors made by the automated system that Wells Fargo and other service providers use. The court recalled that it had previously addressed the failure of Wells Fargo to notify borrowers of fees, costs, or other charges that it had imposed in those prior cases. In this case, Wells Fargo responded to the court's demand for evidence with computer-generated action plans, but not with copies of the letters it claimed to have sent. The court also found that, without informing the debtor, Wells Fargo had assessed late fees, the nonpayment of which precipitated additional late fees and charges of which the debtor was not made aware, since subsequent payments were placed in a suspense account or applied toward late fees and the cost of property inspections triggered by the defaults. The court noted that Wells Fargo charged 13 late fees in a one-year period, as well as seven property inspections, all without notice to the debtor.

The court found that the property inspections, automatically generated by Wells Fargo's management software, were unreasonable and unnecessary. It noted that Wells Fargo had commissioned inspections of the debtor's property on average every 54 days, despite the continued timely payments by the debtor and despite the fact that each of the inspection reports indicated that the debtor's property was occupied and in good condition. While the electronic records were stored, no one at Wells Fargo reviewed the information that revealed that the inspections were not all performed on the same property (the description of the property, for example, varied from "brick construction" to "frame construction" in these reports).

The court also found that only two of the nine broker valuations charged by Wells Fargo (at prices ranging from $95 to $390) fell within the company's stated policies and none of the valuations was provided to the debtor. In addition, the court took note that in an earlier case, Wells Fargo had admitted that it had actually paid only $50 for broker valuations. As a result, the court held that the additional total of $880 charged for these valuations was an illegal undisclosed fee, disguised as a third party cost.

In addition, the court found discrepancies in the management of the escrow account that was set up when the debtor stopped paying property insurance. It determined that increases in the monthly installments to cover the escrow were excessive, and Wells Fargo's application of payments tended to satisfy late fees and inspection charges rather than the actual cost of the insurance.

Similarly, the court found that the late charges applied by Wells Fargo did not comport with the relevant provisions of the mortgage. It found that Wells Fargo had incorrectly interpreted the mortgage to allow for the charging of a late fee each month until the debtor cured a given default, rather than charging only one late fee for each late installment.

The bankruptcy court also found that the adequate protection order (that Wells Fargo had submitted in the debtor's previous bankruptcy case) contained claims to prepetition property inspections, without disclosing this fact to the court or the trustee. The court noted the failure of Wells Fargo's counsel to meet its duty of candor to the court in submitting the adequate protection order, and disallowed the charges for those property inspections. The court similarly combed through the attorney fees and costs incurred by Wells Fargo during the two dismissed bankruptcy cases and foreclosure proceedings (which amounts were included in Wells Fargo's proof of claim in this case), and disallowed fees not actually approved by the court and costs not supported by invoices.

Finally, the court recalculated Wells Fargo's application of payments from the debtor in accordance with the terms of the promissory note and the mortgage. The court then corrected the proofs of claim to reflect the proper application of payments.

In its order, the court sanctioned Wells Fargo $2,500 for presenting the adequate protection order; $2,500 for filing erroneous proofs of claim and misrepresenting the cost of the broker valuations; $12,350 for legal fees incurred by the debtor resulting from prosecution of its objection to Wells Fargo's claim; and $10,000 in damages for failing to give proper notice to the debtor and charging unwarranted fees and costs.

Parting Thoughts

While modern lending practices and the securitization of traditional home mortgages provide greater access to capital markets and more flexibility to lenders, their implementation must include mechanisms to ensure that the servicers of these mortgages act in accordance with standards of fairness and proper notice. In this case, Wells Fargo relied exclusively on its software packages to manage the loan it serviced. Unfortunately, this "hands-off" system imbued only with computer logic continued to generate bills and manage the loan long after a reasonable person might have tempered Wells Fargo's activities.

Simply phrased, automation, which may be effective at repetitive tasks, cannot adapt to conditions beyond its programming. Lawyers who act as counsel to "automated" clients should take great care to ensure that they can substantiate the computer-generated reports with good evidence, and that the records received from their clients are defensible in court.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Adrian C. Maholchic is an associate with the firm and practices in the area of business reorganization and financial restructuring. He graduated from the University of Pittsburgh School of Law in 2007, where he was a member of the Pittsburgh Journal of Environmental and Public Health Law. He is admitted to practice in Pennsylvania and New Jersey.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.