All is Not Lost: Mitigating the Risk of Loss of a Delinquent Collateral Asset in the Era of Autonomous Zones
Following the death of George Floyd during his arrest in Minneapolis, Minnesota, America experienced months of civil unrest throughout the country. It was during these protests that some began to assert that civil society in America was beyond repair and advocated for breaking the shackles of an allegedly oppressive and racially insensitive government. It was from this belief that the idea of establishing autonomous zones free from civil authority and independent from the United States was born. For the first time since 1861, calls for secession were acted upon, and protestors began to commandeer and blockade neighborhoods in major U.S. cities, thereby creating bubbles of autonomous rule within the United States. Protestors denied emergency responders and civil authorities entry to these autonomous zones, and prevented property owners from quietly enjoying their homes and businesses. For days, or even weeks, local and state governments ceded civil authority to the mob before being able to regain a semblance of control over these areas.
The Red House Autonomous Zone in Portland, Oregon, demonstrates the negative impact autonomous zones can have on protecting a lienholder’s collateral assets. The property in question, called the Red House on Mississippi by activists, was owned by the Kinneys, an African American/Native American family. Following a default on their mortgage, the noteholder foreclosed on the property, and it was sold to a developer as a non-judicial foreclosure in 2018. The Multnomah County Circuit Court issued a writ of execution for eviction following a non-judicial foreclosure, and the sheriff’s office served the Kinney family in September 2020. Thereafter, activists in support of the Kinney family occupied the house and denied the new owner access to the property. When the sheriff's department and Portland Police Department attempted to evict the activists in December 2020, the activists violently repelled law enforcement and established a three square block autonomous zone around the property. The creation of the autonomous zone impacted the entire neighborhood and not just the Kinney property. The activists defending the Kinney home were not local residents, but instead activists squatting on the Kinney property. The result was that the Kinneys’ neighbors, who did not ask to be part of the autonomous zone, were forced to become unwilling participants in the protest. Even though the City of Portland was able to negotiate an end to the autonomous zone, the activists still occupy the property and the city has taken no further action to evict them. Thus, the new owner, who has a court-issued eviction order, is unable to gain access to its property due to the government’s refusal to utilize its civil authority to enforce the eviction order.
Even though local governments were eventually able to regain relative control of these autonomous zones, a lasting impact remains. Emboldened by the lack of repercussions for defying civil authority, the establishment of autonomous zones is now seen as a viable protest tool. Moreover, in the case of the Red House on Mississippi, the local government is now unwilling to enforce court orders to forcibly evict unlawful squatters out of fear of creating unrest, thereby denying the holder of legal title to the property and its rights to quietly enjoy the property. In light of this, lienholders need to be aware of their options to mitigate the risk of losing a collateral asset if it becomes part of an autonomous zone. This article discusses considerations lenders should take into account if they are contemplating targeted lending policies to mitigate the risk that their collateral assets will be encompassed within an autonomous zone. Additionally, we discuss the recourse lienholders have if their rights are damaged due to the existence of an autonomous zone that results in the loss of a delinquent collateral asset.
Underwriting Risk Mitigation Policies
Some areas of the country are more susceptible to the establishment of autonomous zones than others. Lenders may be considering employing risk mitigating policies directed at areas deemed more susceptible to autonomous zone control in order to prevent the loss of their collateral assets. Possible risk mitigation policies may include:
- Increasing interest rates where local or state government policies have led to the creation of autonomous zones;
- Requiring the borrower to obtain additional insurance to protect the lender from loss of the collateral asset in the event of its inclusion in an autonomous zone; and/or
- Requiring borrowers to escrow their property taxes with the lender in areas determined to be susceptible to the formation of an autonomous zone to mitigate the risk of the borrower withholding property taxes and having the property foreclosed upon by the local government.
While a lender may want to adopt these risk mitigating policies, careful consideration of federal and state law must be made before any such policy is implemented.
While state consumer credit protection laws compliment the federal Consumer Credit Protection Act, the state law may be more stringent than the federal statute. Therefore, the lender is required to not only conduct an examination of the proposed policy against the federal Consumer Credit Protection Act, but also against the state consumer credit protection laws in each state in which the lender intends to implement the policy. Failure to examine the proposed risk mitigation policy against applicable consumer credit protection laws may result in costly litigation in the future.
If the risk mitigation policy is permissible pursuant to federal and applicable state consumer credit protection statutes, then the lender must also ensure that the policy is not discriminatory against a protected class. Under the Fair Housing Act (“FHA”), implemented through 24 C.F.R. § 100, lenders cannot disparately treat individuals based on their “race, color, religion, sex, handicap, familial status, or national origin.” 24 C.F.R. § 100.5(a). Meanwhile, under the Equal Credit Opportunity Act (“ECOA”), implemented through 12 C.F.R. § 202, lenders cannot disparately treat individuals due to “race, color, religion, national origin, sex, marital status, or age (provided the applicant has the capacity to contract); to the fact that all or part of the applicant’s income derives from a public assistance program; or to the fact that the applicant has in good faith exercised any right under the Consumer Credit Protection Act.” 12 C.F.R. § 202.1(b). While the above referenced risk mitigation policies are neutral in nature insofar as they are directed at localities where state and local governments have historically ceded civil authority to protestors and are not directed at a protected class, lenders must be careful that these policies do not create a “disparate impact” on members of a protected class.
If a lending policy has a disparate impact on a protected class, then it is impermissible, and may result in a discrimination claim, or worse a class action lawsuit, against the lender. Courts have held that “[t]o establish a disparate impact claim, a plaintiff must show an outwardly neutral policy or practice that has a significant adverse or disproportionate impact on members of a protected group.” Taylor v. Accredited Home Lenders, Inc.
, 580 F. Supp. 2d 1062, 1068 (S.D. Cal. 2008) (analyzing disparate impact under both the FHA and ECOA). Additionally, “[t]o establish a prima facie case under a[n ECOA] disparate impact theory, a plaintiff must identify a specific policy or practice which the defendant has used to discriminate and must also demonstrate with statistical evidence that the practice or policy has an adverse effect on the protected group.” Powell v. Am. Gen. Fin., Inc.
, 310 F. Supp. 2d 481, 487 (N.D.N.Y. 2004). Moreover, an analysis of a policy’s disparate impact is critical because it is anticipated that the incoming Biden administration will increase “disparate impact” enforcement. Therefore, lenders considering instituting targeted policies to mitigate the risk of the loss of collateral assets as the result of them potentially becoming part of an autonomous zone must conduct a careful disparate impact analysis before implementing the policies.
Below are our recommendations to lenders who want to be proactive to protect their collateral assets from loss as a result of becoming part of an autonomous zone:
- The lender should conduct an analysis of municipalities that may be more prone to the establishment of autonomous zones due to governmental action or inaction.
- The lender should conduct an examination of each proposed underwriting risk mitigation policy against federal and state consumer credit protection laws in each state in which the lender intends to implement the policy to ensure compliance.
- The lender should craft the policy to be as inclusive and neutral as possible in order to avoid a disparate impact claim.
- The lender should conduct robust statistical and demographic analysis of the area targeted for more stringent underwriting, monitoring for the presence of members of protected groups and the disparate impact the mitigation policy may have on them.
- The lender should make the area targeted for the implementation of the risk mitigation policies as broad as possible. The narrower the territory, such as a block, street or neighborhood, the more likely it is that a court will find that the mitigation policy has a disparate impact on a protected class.
Thus, lenders should proceed with caution when considering implementing policies targeting areas where collateral assets may be at heightened risk of being annexed into an autonomous zone.
Post-Autonomous Zone Recourse for Delinquent Collateral Assets
If a lienholder finds that its delinquent collateral asset is now part of an autonomous zone, or if its collateral asset becomes delinquent as the result of its inclusion in an autonomous zone, all is not lost. The lienholder has recourse against the governmental entities that permitted the establishment of the autonomous zone, including a Fifth Amendment takings claim and/or an inverse condemnation claim under state law. Which claims are available to the lienholder is dependent on the status of the foreclosure proceeding, and the jurisdiction where the claims are filed.
Government inaction or encouragement of autonomous zones frustrates the rights of those who have interests in property that becomes ensnared in the autonomous zone. This frustration of rights can give rise to a viable takings claim against the governmental entity that is impinging on the property owner's rights. The Takings Clause of the Fifth Amendment of the United States Constitution provides, “nor shall private property be taken for public use, without just compensation.” Under the Fifth Amendment, property owners may bring a takings claim when government action frustrates their use, enjoyment, and rights associated with the property, without providing just compensation. If the government is found to have engaged in an improper governmental taking by allowing the establishment of an autonomous zone, then the individuals and entities whose property rights were infringed upon are entitled to just compensation.
Recent legal precedent indicates that a lienholder can bring a Fifth Amendment takings claim at any point during the foreclosure process if the government infringes on its interest in a delinquent collateral asset by allowing the formation of an autonomous zone. In HMC Assets, LLC v. City of Deltona
, 2018 WL 647452 (M.D. Fla. Jan. 31, 2018), the U.S. District Court for the Middle District of Florida held that a mortgagee could proceed with its Fifth Amendment takings claim and its procedural due process claim. In HMC Assets
, the mortgagee foreclosed on a parcel of real estate, and before a final judgment of foreclosure was obtained, the city demolished the building on the property without notice of the demolition or ordinance violations and fines leading to the demolition. As a result of the destruction of the structure by the city, the court held that the mortgagee was entitled to assert a Fifth Amendment takings claim against the city due to the resulting diminution in the value of the collateral property. The court reasoned that “the United States Supreme Court has held that taking of a mortgagee’s rights without compensation can violate the Takings Clause.” In addition, “[u]nder federal law, a mortgagee possesses a legally protected property interest in the premises for purposes of the Fifth Amendment.” Thus, HMC Assets
suggests that mortgagees likely have standing to bring a Fifth Amendment takings claim and procedural due process claims against the government if the establishment of an autonomous zone infringes on a lienholder's interest in a delinquent collateral asset.
There is precedent now available regarding the viability of a Fifth Amendment takings claim against the government related to the establishment of an autonomous zone. In Hunters Capital LLC, et al. v. City of Seattle
, No. 2:20-cv-00983 (W.D. Wash. June 24, 2020), the plaintiffs, including “residents, tenants, property owners, and small businesses in Seattle’s Capitol Hill neighborhood that have been harmed by CHOP,” brought Fifth Amendment takings and Fourteenth Amendment due process claims under 42 U.S.C. § 1983 against the City of Seattle related to the city's alleged inaction and encouragement of the Capitol Hill Autonomous Zone. The city attempted to have these claims dismissed on the basis that (a) the partial and temporary loss of property did not constitute a taking; (b) the plaintiffs failed to show direct harm caused by the city; (c) the due process clause did not require the city to exercise discretion to prevent private actors from harming other people; and (d) the city did not directly place plaintiffs in danger. However, the court sided with the plaintiffs and denied the city’s motion to dismiss. The court held that “Plaintiffs plausibly assert that the City’s endorsement of, and the provision of material support to, CHOP set in motion a series of acts by certain CHOP participants, who the City knew or reasonably should have known would deprive Plaintiffs of protected property interests . . . These allegations support the claim that the City’s conduct was ‘causally related to [the] private misconduct’ and it was ‘sufficiently direct and substantial to require compensation under the Fifth Amendment.’” Hunters Capital
is still pending and the final resolution is unknown. However, the holding Hunters Capital
, together with the holding in HMC Assets
, suggest that lienholders have a viable Fifth Amendment takings claim against the government if it can be shown that the lienholder was deprived of a protected property interest as the result of the government’s endorsement and material support of the establishment of an autonomous zone.
In addition to a Fifth Amendment takings claim, a lienholder also can bring an inverse condemnation claim under state law if the government infringes on the lienholders’ property rights once it has legal possession of the delinquent property. Like a Fifth Amendment takings claim, those with sufficient property interests can file a state law inverse condemnation claim when the government takes their property without providing just compensation. Pursuant to the holding in HMC Assets
, wherein the court held that under Florida law, “a mortgagee such as HMC lacks standing to bring an inverse condemnation claim,” lienholders likely will lack standing to bring a state law inverse condemnation claim before receiving a foreclosure order. Jurisdictions may vary on this issue depending on each jurisdiction’s interpretation of the scope of interests that grant standing to bring an inverse condemnation claim. However, once that order is received, and the lienholder has legal title to the property, then it can certainly bring this claim. Moreover, in relation to the Red House on Mississippi, the owner of the property is entitled to bring a Fifth Amendment takings claim and/or an inverse condemnation claim against the City of Portland.
An aggrieved lienholder who has its interest in a collateral asset infringed upon by the government due to the establishment of an autonomous zone can bring its Fifth Amendment takings and due process claims directly in federal court. This would allow the lienholder to circumvent local state courts that may be less sympathetic to the lienholder's claims. In 2019, the Supreme Court of the United States held in Knick v. Township of Scott, Pennsylvania
, 139 S. Ct. 2162, 204 L. Ed. 2d 558 (2019), that a property owner may immediately bring a Fifth Amendment takings claim under 42 U.S.C. § 1983 to federal court once the property has been taken without just compensation. Knick
overruled earlier precedent that required property owners to proceed through state court first. Specifically, “[w]e now conclude that the state-litigation requirement imposes an unjustifiable burden on takings plaintiffs, conflicts with the rest of our takings jurisprudence, and must be overruled. A property owner has an actionable Fifth Amendment takings claim when the government takes his property without paying for it.” Additionally, “[t]he availability of any particular compensation remedy, such as an inverse condemnation claim under state law, cannot infringe or restrict the property owner’s federal constitutional claim.” Thus, Knick
allows circumvention of the “home cooking” of state courts, which is beneficial for lienholders. Federal supplemental jurisdiction allows the lienholder to also bring any viable state court claims, including an inverse condemnation claim, in federal court together with the lienholder's federal constitutional claims. This allows the lienholder to avoid the possible biases held by local state court judges, and provides for a hopefully more objective evaluation of the lienholder's claims.
The birth of autonomous zones has led to uncertainty regarding the protection of a lienholder's collateral assets, and raises new considerations that lienholders never had to consider in the past. Lienholders wishing to implement targeted risk mitigation policies for areas at heightened risk of autonomous zone control should proceed with caution prior to implementing such policies and should follow the steps outline above. The good news is that recent case law on this new issue suggests that a lienholder likely has a viable takings claim against the government, which can go directly to federal court, if municipal inaction and encouragement of autonomous zones frustrates the lienholder’s interests in a delinquent collateral asset.
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if you have any questions about this issue or any consumer finance issues.