Welcome to our new readers from the FCIC.

Lender Processing Services, a crucial player in the residential mortgage servicing arena, has been hit with two suits seeking national class action status (see here and here for the court filings). If the plaintiffs prevail, the disgorgement of fees by LPS could easily run into the billions of dollars (we have received a more precise estimate from plaintiffs’ counsel). To give a sense of proportion, LPS’s 2009 revenues were $2.4 billion and its net income that year was $276 million.

These suits, one of which was filed late last week, the other Monday, appear to be the proximate cause for the sharp drop in LPS stock, which fell 5% on Friday and 8% Monday (trading was halted just prior to the close of the trading day).

Those close to the foreclosure process have lodged many complaints against LPS. But the two suits we highlight here level the most serious and wideranging allegations thus far.

By way of background, we’ve described issues with foreclosure mills and the flaws in the securitization process at some length in previous posts (see here and here for some recent posts which contain overview material). As evidence about problems with the foreclosure process have surfaced at more and more servicers, one of the common themes has been that a substantial portion of the foreclosure process was outsourced to various processing companies. Foreclosure defense attorneys have cited one firm, called Lender Processing Service (LPS) as one of the largest as well as more problematic firms in the outsourced foreclosure business. In addition, by 2008, LPS had purchased a company called DocX, the company responsible for the “document production” price sheet cited here earlier.

LPS is effectively in three lines of business (which are organized in two divisions): Technology, Data, and Analytics; Loan Services, and Default Services. The suits focus on the practices of the Default Services operation, which contributed $1.137 billion, or 48% of total revenues. The allegations set forth in the suits involve its Default Services, which organizes and manages foreclosures (including property management and REO auctions) on behalf of servicers.

But the rub in this line of business is that the servicers are technically not the clients. LPS acts a sort of general contractor, farming out various tasks to both internal staff as well as outside firms. But LPS’s business pitch to the servicing industry was that it would come in and use a technology platform and provide (if desired) a turnkey solution, FOR NO ADDITIONAL COST than what the servicers were already paying on foreclosures.

How could that be? All of LPS’s revenues in Default Services come from the lawyers in the national network of foreclosure mills that LPS has developed over time. Note that these cases may be filed in state court or federal bankruptcy court, depending on the situation of the borrower. In a routine foreclosure, all legal actions will be filed in state court. If the borrower has filed for a Chapter 13 bankruptcy, the Federal bankruptcy court has jurisdiction. In theory, the bankruptcy filing stops the actions of all creditors until the borrower has worked out a payment plan with the court. But in these cases, LPS and its network firms are seeking to break the bankruptcy court time out and grab the borrower’s house (the legal procedure is “motion for relief of stay”).

To illustrate the degree of control LPS exercises over its network: we have been told by an LPS insider that the software that LPS uses to coordinate with all law firms in its network, LPS Desktop, incorporates a scoring system called 3/3/30. When LPS sends a referral on a foreclosure, the referee is expected to respond in three minutes. When it accepts the referral, it is auto debited (ACH or credit card). In three days, it is expected to have filed the first motion required in pursing the case, and it is expected to have resolved the case in 30 days. Firms are graded according to their ability to meet these time parameters in a green/yellow/red system. Firms that get a red grade are given a certain amount of time to improve their results or they are kicked out of the network.

The cases describe the many fees between LPS and the network law firms. The terms of standard agreements provide for the payment of $150 at the time of referral (the first 3 in the 3/3/30 standard above). Network firms allegedly pay other fees as various milestones are reached, and these are couched as fees for technology, administrative review, document execution, and other legitimate-sounding services. We’ve also been told separately by LPS insiders that LPS and network law firms split the fee for the motion for relief of stay in bankruptcy court, as well as the fee on a small filing called a proof of claim.

What, pray tell, is wrong with this business model? The two suits attack LPS’s very foundations. One case was filed late last week in Federal bankruptcy court in Mississippi and the other in state court in Kentucky. Both make similar allegations, but the Federal case is broader in some respects (it includes a company called Prommis Solutions a firm backed by Great Hill Partners, that like LPS, provides services to foreclosure mills, including one named in this case as defendant along with LPS).

The Kentucky case includes on the RMBS trust issue that we have discussed in this blog. First, it contends that the mortgage assignment attempted by the the local law firm to allow the trust foreclose was a void under New York law, which governs the trust. Hence the foreclosure was invalid. Second, it claims that the defendants (the local law firm and LPS) fabricated documents. Third, the plaintiffs claim that the defendants (LPS and the local law firm) conspired together to practice systemic fraud upon the court and engage fee sharing arrangements, which is tantamount to the unauthorized practice of law (It is illegal for a law firm to split fees with a non-lawyer or to pay a non-lawyer for a referral; it’s considered to be the unauthorized practice of law). And this leads to some very serious conclusions. Per the Kentucky case:

This attempt by the Trust to take Stacy’s real property is most analogous to stealing since this Trust cannot provide any legal evidence of ownership of the promissory note in accordance with the requirements of New York law which governs and controls the actions of the Trust and the Trustee acting on behalf of the trust.

But the real meat in these cases are the class action claims, and they are real doozies. Both allege undisclosed contractual arrangements for impermissible legal fee splittings, which are camouflaged as various types of fees we described earlier. The suits describe the considerable lengths that LPS has gone to to keep these illegal kickbacks secret, including requiring that all attorneys who join the network keep the arrangement confidential. as well as using dubious “trade secret” claims to forestall their disclosure in discovery.

As bad as this fact pattern is, it has even more serious implications for the bankruptcy court filing in Mississippi. In a bankruptcy case, any attorney pleading before the court must disclose every disbursement pursuant to a case, no matter how minor. Yet the payment of fees to LPS have never been disclosed to a single bankruptcy judge in the US, since LPS requires they be kept confidential. LPS and its network lawyers are thus engaged in a massive, ongoing fraud on all bankruptcy courts in the US.

The Prommis Solutions/Great Hill charges are included only in the Mississippi case. Prommis is broadly in the same business as LPS’s Default Services unit (“leading provider of technology-enabled processing services for the default resolution sector of the residential mortgage industry”). And Prommis and its investor Great HIll, like LPS, are not a law firms, which means their participation in foreclosure-related legal fees constitutes illegal fee sharing. Prommis filed a registration statement (it planned to go public) this past June. Consider this section from its “Risk Factors” discussion (boldface theirs):

Regulation of the legal profession may constrain the operations of our business, and could impair our ability to provide services to our customers and adversely affect our revenue and results of operations. Each state has adopted laws, regulations and codes of ethics that grant attorneys licensed by the state the exclusive right to practice law. The practice of law other than by a licensed attorney is referred to as the unauthorized practice of law. What constitutes or defines the boundaries of the “practice of law,” however, is not necessarily clearly established, varies from state to state and depends on authorities such as state law, bar associations, ethics committees and constitutional law formulated by the U.S. Supreme Court. Many states define the practice of law to include the giving of advice and opinions regarding another person’s legal rights, the preparation of legal documents or the preparation of court documents for another person. In addition, all states and the American Bar Association prohibit attorneys from sharing fees for legal services with non-attorneys.

The common remedy for illegal fee sharing is disgorgement. Remember the magnitude of this business: it accounts for nearly half of LPS’s revenues. LPS is a pretty levered operation, with a debt to equity ratio of over 3:1. It isn’t hard to see that success in either of these cases would be a fatal blow to LPS. Similarly, if the allegations are proven true it could have ramifications for all servicers who do business with Fannie and Freddie since they are not supposed to be involved in referring work to a vendor who pays a kickback for a referral.