United States: The First 100 Days and Beyond: ILSA Now Administered by the Federal Consumer Financial Protection Bureau

Robert Chasnow is a Partner in our Washington, D.C. office

The Dodd-Frank Wall Street Reform and Consumer Protection Act, effective July 21, 2010, focuses extensively on banking and securities. Title X of the Act (codified at 12 U.S.C.A. Section 5511) establishes the Consumer Financial Protection Bureau (CFPB or the "bureau") and grants it extensive authority over banking and securities. In addition, Title X also consolidates under the bureau's authority administration of a number of consumer-oriented financial and real estate laws as of July 21, 2011, including the Interstate Land Sales Full Disclosure Act (ILSA), 15 U.S.C. 1701 et seq. For the past 40 years, ILSA had been administered by the U.S. Department of Housing and Urban Development (HUD). This alert is a continuation of the July 21, 2011 Real Estate alert, Crossing the Rubicon: ILSA Now Administered by the Federal Consumer Financial Protection Bureau, which described the then upcoming transition from HUD to CFPB.

The daily operation that is most visible to developers is the CFPB staff review of new or amended registrations and annual reports of activity for lot sales in new subdivisions and communities, and some vertical yet-to-be-built condominiums. The relatively prompt pace of review of the principal staff member, Mr. William Thomas, has remained constant. Mr. Thomas, who was the main registration and exemption examiner for the past few years at HUD while ILSA was administered by HUD, transferred along with ILSA to the CFPB and holds a similar position there. Dennis Weipert, who focuses on enforcement and policy issues, also transitioned from HUD to the new agency. So, the two main persons who administered the daily activities of the ILSA program over the past few years at HUD continue to do so for the CFPB.

Standards for Registration Continue to Tighten

The standards for disclosure in the property report and the additional information and documentation section continue to tighten. Answers that were accepted by HUD for years are now routinely found lacking. One who is not experienced with recent standards can expect 20 to 30 punch list items and sometimes more. Some are straightforward to resolve but others are not. For example, in situations where unaudited financial statements are permitted by the regulations, for many years such financial statements would be filed without a signed certification by the preparer. However, starting a few years ago, a certification is required that the unaudited statements meet the standards of Generally Accepted Accounting Principles (GAAP) of the Financial Accounting Standards Board (FASB), a nonprofit organization of the accounting profession created to promulgate GAAP rules.

As a second example, a provision in the regulations under which the agency may require any additional information and documentation for insertion into property report disclosures not expressly required by the regulations, but may be required in the public interest and for the protection of purchasers, historically was sparingly invoked by HUD examiners. Discretion of the examiner now reaches further than perhaps ever before. There are differing opinions on whether the information thus obtained is beneficial or useless to prospective purchasers. The main shortcomings of this approach, when additional disclosure requirements are routinely mandated, is the element of surprise, and the lack of opportunity to comment prior to issuance and to have comments fairly considered free of the investment of the examiner in the deficiency. Notice and opportunity to comment and be fairly heard is the core of the regulatory rulemaking process or published policy pronouncements. When examination becomes an unpredictable black box, erosion of sound administrative procedure and fundamental fairness results.

It is difficult for the developer trying to register or amend and also for the CFPB examiner who has a tough job to be sure. With wide discretion on issues of disclosure and documentation in registration, the examiner is left to pore over the statute and regulations and accumulate a punch list of items built up over time. The list tends to reach for more detailed disclosures – not all of which are either expressly called for in the regulations or particularly meaningful to a prospective purchaser. Nonetheless, the accumulated discretionary punch list contributes to a substantially lengthened registration cycle costly in time and dollars to developers who are already working hard to comply.

An example of a new deficiency is one recently cited seeking a copy of the deed by which the landowner obtained title to the property being registered. This deficiency was cited even though the requirement is not in the regulations, was never before required, and despite that the regulations already require current title insurance or other current title evidence to show title in the name of the registrant or registrant-related entity. Use of a title insurance policy, commitment or similar evidence – per the regulations – is a method of title inquiry superior to producing a deed copy since the deed itself is likely to be years old with a metes and bounds property description that is difficult to match to the recorded plats which likely were filed in the interim. In contrast, the title search must be current to within 20 business days of filing and must align the developer with the specific lots or units being offered. For good reason, the requirement was not carried over from the statute to the regulations despite at least six rounds of rulemaking during the years HUD administered ILSA. However, because the provision is found in the statute, the examiner now considers it as a standard requirement.

As described, registration requirements are being ratcheted-up without notice or opportunity to comment. A sense of balance seems to be missing – consideration of a cost-benefit measure to developers or consumers. Recently, a federal judge rejected proposed SEC rules for lack of adequate cost benefit analysis. While litigation is not necessarily the best option, the need for balanced regulation is important. In the recent spate of ILSA litigation, several decisions note that not every disclosure in a property report is legally material to a purchaser. Likewise, not every crevice and eddy of the statute and regulations should yield fodder for new deficiencies.

At the same time, the examiner tries to give notice of some changes. For example, the examiner will now use the term "deficiency response amendatory material" (found in section 1710.21(a) of the regulations) and the acronym "DRAM" in reference to a developer's answers to a deficiency list.

CFPB to Emphasize Transparency and Public Participation

In recent years HUD did not appear to focus on ILSA, shaved its resources and with two significant exceptions did not offer amicus briefs defending its long time ILSA practices and policies when the practices were questioned or upended in private litigation. When Dodd-Frank was enacted in 2010, there was a sense of optimism that ILSA would receive more attention from CFPB policy makers and that the long years of drift would be over.

Despite what some might wish, one can't expect reform of ILSA and its administration to be a top priority for the CFPB for the reason that programs involving home loans, credit cards and student loans are more closely related to the present debit and credit crisis dramatically affecting millions of Americans (see, e.g., www.cfpb.gov for information on the bureau's attention to these core issues), whereas ILSA's impact is far more limited. These programs understandably take priority for the bureau.

However, more generally across the board for CFPB programs, principles articulated by top executives at CFPB speak of simplification of disclosure, and transparency and accountability of the agency.

On November 2, 2011, Special Advisor to the Secretary of the Treasury for the Consumer Financial Protection Bureau Raj Date submitted a report to Congress on the topic, "The Consumer Financial Protection Bureau: The First 100 Days." Mr. Date emphasized that the CFPB is

Mr. Date concluded his presentation by explaining the CFPB's approach to regulation:

(Read the full text of the CFPB's presentation.)

Although the flowering of these policies applied to administration of ILSA is not yet apparent, the CFPB deserves a reasonable period of time for implementation and one can remain optimistic that the ILSA program will become more open and streamlined. Application of enlightened ideas could bring significant improvement in ILSA administration and compliance. One hopes that such steps are or will soon be considered by the CFPB's Non-Bank Supervision group of the Supervision, Fair Lending and Enforcement Division that administers ILSA. As an important example, placing copies of the final versions of property reports and exemption issuances online along with a searchable database of registered projects, exemption advisory opinions, exemption orders and other exemption materials, and settlement agreements would be a step forward in transparency and accountability. This would not require a change in the statute but would be of high value to both purchasers and developers. Currently a time-consuming Freedom of Information Act procedure is in place which does nothing so much as to bury documents whereas the bureau should be encouraging dissemination and circulation consistent with its professed policies.

Will CFPB Address the Issue of ILSA Application to Condominiums?

It's common knowledge that upon the original 1968 passage of ILSA, there was not the slightest evidence of legislative intent to apply ILSA to condominiums, only that housing including the condominium form of residential dwellings would be exempt. Indeed, entirely separate from ILSA, in a congressional session in the early 1970s, a bill to provide federal regulation for condominium development was proposed but for lack of support never came to a vote. Statutory amendments to ILSA in the decade of the 1970s touching on the issue were efforts by Congress to emphasize the exempt status of condominiums rather than to include them under ILSA jurisdiction. HUD's several iterations of exemption guidelines sadly declined to be clear on the matter, but the fact is that originally, HUD staff intended to apply ILSA only to a rare breed of condominium known as a "horizontal" condominium regime in which all "units" (lots) are platted on the ground, just as with a typical subdivision plat. The only difference between a "condominium subdivision" and a traditional subdivision is that with a condominium subdivision the recreational facilities, such as a swimming pool and clubhouse, would be common elements of the condominium owned in undivided interest by the lot purchasers as part of their lot deeds, whereas in a traditional subdivision the pool and clubhouse are owned by a property owners' association or as a private club with the lot owners being members of the association or club. A small number of condominium subdivisions were registered over the years without fanfare.

The early court decisions, not receiving any direction from HUD via amicus briefs, tried to give weight to HUD's exemption guidelines but misunderstood HUD's position to mean that ILSA covered all forms of condominium development. HUD's silence as to original intent, its tacit acceptance of the court decisions extending ILSA application and the steady drip in the two decades following the early precedents of further court decisions leaning on the relatively few precedents finding in favor of jurisdiction over midrise and high rise condominiums all combined to give rise to unprecedented levels of litigation in 2008-2010 of purchasers of vertical condominium units suing developers for rescission under ILSA.

There are rumblings that the CFPB may be taking a fresh look at the issue. If true, this is one area of reform of ILSA where various interests can expect to be heard. Given that most states have longstanding condominium regulation – some with very substantial regimens such as California, Hawaii, Florida and New York, and all with state-based bodies of law built up over a 30-year period – is a federal overlay needed? If ILSA regulation is applied to condominium development, will it tend to promote or hinder recovery of the housing sector? Even assuming that a uniform, national system of condominium regulation contributes to consumer confidence, when courts in various states and federal circuits exercise their powers of decision we have seen how greatly ILSA verdicts can vary thereby eroding benefits of national uniformity and instead having the opposite effect of throwing a wet blanket of uncertainty over developer plans and execution.

The rationale of uniformity as a benefit of ILSA application to condominiums is subject to a second serious concern: ILSA does not preempt state laws. To the contrary, it merely created a new second layer of regulation often dovetailing inexactly, redundantly, or in a contradictory fashion with state requirements. ILSA already contains section 1708 (15 USC 1708) which provides for HUD (now CFPB) to enter into agreements with states to consider the state's regulation as fulfilling the agency's requirements, and a few states such as California and Arizona have current agreements. However, for the most part, this provision was found unworkable by states that had considered it or a state's regulations were not considered equivalent by HUD. Whether rejected by the states or by HUD, almost no state condominium statute and few state land sales laws currently participate in the section 1708 equivalence program – even after years of effort by HUD to encourage state participation. Why wasn't the equivalence program more successful? Simply put, historically, states did not want the federal government encroaching on state regulation of land sales and condominium developments. And today, after the recent history of federal failure to prevent the collapse of the housing market, it hardly seems the states now would welcome federal involvement in one of the few regulatory niches in housing to which no one has yet attributed a role in the collapse.

These and many other points will be aired, but a key question relates to the process that the bureau will follow in its consideration of the condominium issue. CFPB has stated on numerous occasions that its approach to regulation will emphasize research and study of the issues, transparency of its deliberations, and welcoming of public participation and scrutiny. Thus far, as to the ILSA program, there have been small steps in this direction although most would probably agree that no great leap towards openness has been observed. Mr. Date's presentation to Congress strikes the right note: a commitment to research and data analysis, having no political agenda, using smart ideas to match solutions to the real problems, with accountability to all parties – all by use of a process that is transparent and participatory. Will these important hallmarks be implemented?

ILSA in 2012 and Beyond

With only micro-market exceptions, the home site and community development industry has been hit hard and is weaker today than at any time since ILSA's passage in 1968. At the time of ILSA's passage in 1968, the condominium industry was in its early years. It has become an important housing form in many American metro areas, but today it is beset by unprecedented inventory overhang and severe downturn that has stifled new projects. Home site sales volumes also have shrunk dramatically. Consequently, the number of ILSA-registered subdivisions and condominium projects has been slashed.

There is speculation that only about 180 subdivision and condominium projects are registered from throughout the United States, even including resort and high-end retirement projects in Mexico and the Caribbean that market into the U.S. and are thus subject to ILSA – a far smaller number compared with 10 years ago. And even that number is probably high once one subtracts projects that are not in active sales. For many years under HUD's prior administrative regime, up to 10 percent or more of registered projects which for reasons of sell-through of project inventory or downside challenges leading to halt in sales, developers would easily have obtained voluntary suspensions pursuant to section 1710.21 (b) of the regulations which states that the only condition to voluntary suspension of the registration is that no formal HUD administrative proceeding is pending. However, it is now much harder to obtain a consensual voluntary suspension of the registration with new requirements including payment of fees from past annual renewals, updating of past filings, and perhaps most important, a new requirement that not even statutorily exempt sales can be made once the voluntary suspension takes effect. So a number of filings are caught in a ride through the twilight zone – developers wish to get off the ILSA registration bus and feel they have a statutory right to do so but find the driver locks the exit doors at the bus stops and accelerates rather than facilitating safe departure.

The illogic of the new policy is particularly evident when applied to registered condominium projects. Some developers of multistory condominiums registered them prior to or during the early phase of construction because the sales would not meet the requirements of the two-year obligation-to-build exemption. However, even when construction is now complete and thus presumably all sales are exempt under the completed dwelling exemption, the requirement of continued use of the property report, federal rescission period and other requirements could remain in effect until final sell-out of all completed units. This outcome was inconceivable for the first 40 years of ILSA administration.

The name of the new agency and its watchword is consumer protection. However, reasonable people may differ as to the line between proper regulation and over-regulation. The key point is not to move the arrow of consumer protection in one direction or another or to criticize the staff assigned to the ILSA program at CFPB, but to suggest that administrative rulemaking and related transparent and inclusive steps are the proper approach to revisions of the agency regulations and longstanding agency interpretation. Similarly, if the bureau initiates a package of amendments to ILSA to forward to Congress, will the bureau champion an open, inclusive process or allow only limited, select input?

However, say what one will about lofty precepts, tightened standards for registration is today's reality. The paradoxical effect of the bureau's daily work is to load more complex and time-consuming requirements on the backs of fewer and fewer developers – the very ones who are trying to comply and not claim exemption. At key junctures the current regulatory policy seems counterproductive thereby making it harder for well-intentioned developers to register and maintain a registration, and exacting a heavy price to delist. And all of this sans rulemaking or policy guidance and without opportunity for organized comment and consideration.

With the transition of ILSA to the CFPB, experienced practitioners will work hard to engage the bureau in a constructive role in the revival of the industry while destroying once and for all the false construct of a zero sum game between developer success and purchaser protection. Doubtless, the bureau, developers and purchasers all can "win" with smart regulation. For developers and other industry participants, it is important to align with counsel who deeply understand where ILSA has been while also understanding the potential for a win-win paradigm of how ILSA can now evolve. The various constituencies involved in residential real estate development and sales, including large scale community developers, lot sales subdivision developers, residential and condominium builders, marketers, and savvy lenders have a great stake in ILSA and should seek informed, constructive engagement in the process. And it is not as if the CFPB has the luxury of time; even if ILSA is not a "crisis statute," if it is to have a meaningful role in the housing industry of the future, the bureau must soon begin a sustained insightful review with plenty of open input from stakeholders.

www.hklaw.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.