(Originally Published in the January/February 2009 Issue of HousingWire Magazine)

The Pursuit of Justice, and a Liquidity Event

Law firms that manage foreclosures have found a creative way to work with private equity, but it’s unclear what the future holds

By Andy Johnston

The topic of foreclosure has been on more people’s minds than I can ever remember in the past. Yet despite the unprecedented scrutiny around the public policy, economic and social effects of the rising wave of foreclosures in America, few people probably understand how a foreclosure is actually executed.

This article is meant to elaborate on the foreclosure process, and shed some light on a recent trend of outsourcing the back office tasks of foreclosure to Business Process Outsourcing (BPO) firms. Before we get there, however, it’s probably instructive to describe some of the guts of the foreclosure machine.

In most states (notably, however, not California) and counties, a servicer must use a so-called judicial process through the services of a law firm to execute a foreclosure. The non-judicial jurisdictions use a trustee instead of the courts to administer foreclosures, and a trustee firm is employed by servicers to act on their behalf.

Servicers vary in their approach to dealing with these law firms and trustee firms, but by and large most servicers will contract with a select number of firms that they deem to be effective. Servicers ultimately must answer to their investors, and therefore servicers look to employ vendors, including law firms, which keep their investors happy.

Fannie Mae and Freddie Mac are the largest mortgage investors in the U.S. – collectively, the GSEs own or guarantee roughly half of all outstanding mortgage debt nationwide- and their opinion and ranking of foreclosure law firms carries a significant amount of influence. The GSEs have a review process which includes a series of interviews as well as a checklist of criteria for how a foreclosure law firm is setup to handle loan files and execute foreclosures. Law firms that apply for and obtain their approval receive the title of “designated counsel” which entitles the firm to handle the GSEs’ foreclosures. This represents such a large portion of mortgages in almost any geography that it is a prerequisite for growth for any regional law firm aspiring to be super-regional or a national player.

Most importantly, the GSEs set forth a fixed fee schedule for reimbursing law firms for handling a foreclosure, with a detailed fee schedule for almost any conceivable turn a foreclosure could take in the legal process and “milestone” payments meant to reimburse the cost of a foreclosure being cancelled after it’s been submitted. This fee schedule dominates the marketplace and defines the cost structure all of the players have to operate within. The GSEs also establish a timeline for completing a foreclosure in each jurisdiction which has also become the standard in the industry. This environment drives law firms to deliver their service at the lowest cost possible, while still meeting their target metrics for timeliness and accuracy.

Law, by any other name

Just as investors use servicers to avoid having to deal with thousands of borrowers individually, servicers employ technology and services vendors to manage their multiple foreclosure law firm relationships. A national servicer could have several law firms in every state they service loans in, resulting in a large network of law firm relationships they would have to manage individually. Most of them opt instead to employ a vendor management solution – with Lender Processing Services (formerly Fidelity National Information Services) being the most popular vendor management solution provider in this space.

LPS maintains a “scorecard” application which tracks, to the minute, how quickly a foreclosure law firm responds to a new loan file submitted to them, how quickly they move those files through the process and how often they result in a successful foreclosure. Some law firms would appoint employees on a full time basis to monitor their case file submissions from LPS, even on weekends, to ensure they quickly clicked the right buttons in order to show a prompt response time and maintain a positive score. Servicers and their investors would use the output of this scorecard to measure firms against their target timelines for completing foreclosures.

Needless to say, this is not the classic approach to the profession of law most of us outside of the foreclosure legal community envision. Even before the subprime crisis began, foreclosure law firms were focused on making profits by handling as many cases as possible with as few legal professionals as possible.

Law firms built large processing centers staffed by paralegals and other non-legal professionals to handle as much of the file preparation as possible. This typically involved preparing source information from the servicer and filling out the forms correctly for the jurisdiction responsible for adjudicating the foreclosure before submitting the foreclosure case file to the court.

Attorneys are required to review each case file and sign off on them, but even this process has been brought to a “piece work” approach at some firms where attorneys could work on a “per file” fee basis.

One can quickly imagine how quantity versus quality is a temptation with this kind of environment. The servicers are paying a flat fee for each file they hand you. High quality service will generally just keep the servicer customers you have and might help you win the next one, though in this industry that’s probably more related to networking and relationships than anything else.

The “80/20” rule applies in this case, as in most BPO situations, meaning 80 percent of the foreclosure cases proceeded through the courts with a very predictable timeline and outcome. One very common occurrence in a foreclosure is the borrower filing for bankruptcy so most foreclosure firms also offer to represent servicers in bankruptcy court as well – with a similar approach to preparing and submitting filings. Assuming the borrower doesn’t challenge anything (and historically, they generally do not) and the loan file is in good order, an attorney will not have to appear in court or touch the file after it’s been submitted.

This system worked reasonably well, under normal conditions. It was characterized, like most service industries, by trade organizations (like the AFN and USFN), certification by the major customers (“designated counsel” was much like making it onto a preferred vendor list) and business was won or lost through relationships with servicers and their management (the MBA Servicing conferences were heavily focused on networking), as well as maintaining a good reputation for effectiveness and efficiency – especially as measured by LPS’ scorecard tool against the GSEs’ timelines.

Expansion by decoupling the back office

Law firms that wanted to expand could invest in their operations to add capacity and then pitch servicers on assigning them more loan files, approach existing firms about merging or - more uniquely - the expanding law firm could acquire the back office of another firm along with a long term contract from the selling firm to submit the selling firm’s case files to the acquired back office.

This last technique became the favored strategy by law firms as well as private equity groups who were looking for a way to invest in the loan default management business. Since law firms can only be owned by lawyers, the private equity investors needed a strategy to invest in this business that didn’t involve taking ownership of the firm.

They saw a classic situation for a “roll-up”, where a private equity group invests in one player in an industry, then acquires several smaller players to form a dominant competitor who can be sold or taken public at a premium valuation.

The foreclosure back office situation was also a classic BPO opportunity: Law firms, to be generous, are not known for their business process design acumen. Several large foreclosure law firms grew by simply growing headcount to handle increased volume. Investments in technology were spotty with most large law firms using expensive custom-developed application as opposed to an off the shelf enterprise workflow application. A few law firms tried using offshore labor, but the results were limited success and limited enthusiasm to invest further.

Faced with a classic roll-up opportunity, dominant foreclosure law firms and private equity groups have made acquisitions of back offices at key foreclosure law firms throughout the nation. Dolan Media’s subsidiary American Processing Corporation recently executed one of these acquisitions by acquiring National Default Exchange (known as NDex) which represented the back office of Barrett Daffin Frappier Turner & Engel, LLP, a large regional foreclosure law firm. NDex was partially owned by a private equity group itself, and had bought/invested in the back office of Barret in 2007. American Processing was itself originally the back office of Trott & Trott, PC, a Michigan-based law firm, before being bought by Dolan.

There are other examples. Prommis Solutions (formerly knows in the industry as MR Default) is another large outsourced back office provider, and was the back office of McCalla Raymer before a private equity group acquired them and began acquiring other back offices.

Why it worked

From my consulting experience and investment banking experience, I can see how these deals are compelling for all parties involved. The fractured nature of the foreclosure law firm market and the wide gaps in technology and business process approaches meant there were significant opportunities to pay a seller a good value for their asset, fold that asset into an improved, existing operation and then sell a much more valuable asset to a larger player for a significant return. I can also see several significant drivers of these deals.

A portion of this acquisition strategy was driven by consolidation at the servicer level. With Countrywide being bought by Bank of America, Wachovia being bought by Wells Fargo and a handful of other servicers dominating the industry, it became apparent that large servicers wanted to deal with a handful of law firms that could provide them high capacity and broad geographic coverage. The firms that met those tests would become the champions and competing smaller firms would be left to pick up the scraps.

Another compelling reason to sell off a back office asset was the value proposition to the selling law firm. This was likely the only way the partners of the firm would realize a significant liquidity event for their equity ownership of the firm. While valuation is rarely disclosed in these types of transactions, it is fair to say that most selling partners could comfortably retire on their share of the proceeds from the sale.

Partners also saw a compelling business reason to enter into this type of transaction. They would typically enter into a long term contract with the buyer, whose back office was likely more efficient and advanced than theirs. It represented a way to quickly modernize their back office and not worry about designing and improving their back office to accommodate future growth strategies.

Significant challenges, borne by the nation’s housing crisis

Today’s market has brought significant challenges, however, to these firms. Law firms now face an unprecedented ramp up in volume, increased legal effort stemming from judges who are imposing new and sometimes unannounced requirements on foreclosure proceedings, borrowers who are looking for ways to challenge foreclosures and legislators at the local, state and federal level who are discussing or imposing foreclosure moratoriums – a solid whack at the pocketbook, when your fee schedule calls for foreclosures to be successfully closed out to collect the bulk of your anticipated payment.

While foreclosure firms have historically offered loss mitigation services alongside foreclosures, these loss mit steps are now coming under tremendous focus. As foreclosures become more costly to investors due to declining property markets, law firms and their back offices are now being asked to handle a rising volume of loss mit activities such as borrower interviews, loan file reviews, collecting paperwork from borrowers and transaction steps necessary to implement a change to a loan.

This can introduce a conflict of interest for the firm if the loan is also under foreclosure - a loss mitigation process could delay the foreclosure, causing timelines to be missed, and may result in a foreclosure down the road if the borrower redefaults, meaning the investor has lost more money in the process than if they had simply foreclosed the first time. This is a combined burden on both the servicer, law firm and law firm back office.

This increasing demand for loss mitigation also requires innovation and progressive use of technology and capabilities. And as mentioned earlier in this report, most of the successful foreclosure law firms did not get where they are by buying the most flexible software, or adding more headcount than volume demanded. Instead, they made profits by limiting costs (mostly driven by headcount) to below the fixed fees they were receiving, and won new business by expanding their networks within the servicer community.

Since innovation was not rewarded with premium fees, there was little incentive to invest in projects that didn’t have an immediate payback. And when the biggest foreclosure law firms began selling their back offices to investors tied to long term service contracts, the incentive to innovate became even lower as little of the process was under the law firm’s control at that point.

What the future holds

These challenges will continue to face foreclosure law firms for the foreseeable future. I predict that some large scale BPO vendors such as Accenture or IBM will make a play in this space. There is significant reputation risk (or “60 Minutes risk” as one private equity group put it to me) of being involved in this space. No one wants to be dragged in front of Congress or the media to explain why a clerical error on their part resulted in the unnecessary eviction of a homeowner.

These concerns are balanced by the enormous market opportunity represented by the swelling volume of foreclosures, and the demand for these services being generated by financial services companies who are key clients of these BPO vendors. The use of enterprise technology vendors (Oracle, IBM, etc.) and offshore resources will also become more common. Larger BPO vendors entering this space will accelerate their adoption.

And finally, until the fixed fee model is changed, there will likely not be a major redesign of the outsourced back office model approach to foreclosures. Now that the U.S. Government effectively owns the GSEs and Congress is spending a significant amount of time contemplating how foreclosures should be handled, there is a real chance that fee model could change. Until then, you will see foreclosure law firms incented to use the lowest cost labor they can find to effectively execute foreclosures.

Andy Johnston is a partner at an investment bank, 7 Mile Advisors. He is focused on advising technology-enabled business services companies on preparing for and executing Mergers and Acquisitions as well as other corporate finance transactions.