The Obama administration and Congress are advocating for more mortgage modifications. One constraint is the large number of mortgages held in securitization trusts, and the fact that parties servicing these loans may have contractual obligations that limit their ability to modify loans.

In response, Congress is considering proposals to provide immunity for servicers that modify certain loans in lieu of foreclosure. Some argue that these "safe harbor" proposals are unconstitutional, usually citing the prohibition on the abrogation of contracts. However, the case law indicates that a well-drafted provision should have no trouble in passing constitutional muster.

Some of the arguments have been framed around the Contract Clause, but this provision is not applicable to the federal government. The clause says: "No State shall … pass any … law impairing the Obligation of Contracts." By its terms, it does not apply at the federal level, and the Supreme Court has affirmed this interpretation on many occasions.

The Fifth Amendment, on the other hand, is applicable to the federal government. This amendment provides that private property shall not be "taken for public use without just compensation." The court has held that regulation of private property, including contract rights, may be "so onerous" in some cases as to constitute a "taking" under the Fifth Amendment. This concept is known as a "regulatory taking."

However, the Supreme Court recognizes that the government could not function if it were required to pay compensation whenever a property interest were compromised. In Penn Central Transportation Co. v. New York City, the court analyzed the issue of regulatory takings by looking at three factors: the economic impact on the party involved, the nature of the action (e.g., a "physical invasion" or a public program that merely affects property rights) and the extent to which the regulation has interfered with distinct investment-backed expectation.

For example, bondholders sued under the takings clause when federal actions kept the money-losing New Haven Railroad in operation, thereby decreasing the bondholders' ultimate recovery. The court dismissed the claim, explaining: "While the rights of the bondholders are entitled to respect, they do not command Procrustean measures. They certainly do not dictate that rail operations vital to the nation be jettisoned despite the availability of a feasible alternative. The public interest is not merely a pawn to be sacrificed for the strategic purposes or protection of a class of security holders."

Similarly, the court found no regulatory taking when Penn Central lost the right to construct a 57-story office building above Grand Central Station. The court focused on the economic impact of the historic preservation determination, and it put significant importance on the fact that Penn Central could still earn a "reasonable return" on its investment by operating the property as a rail terminal.

The court also noted that the action was in furtherance of the public welfare and was not aimed at appropriating property.

In Andrus v. Allard, the court upheld a law that made it illegal to sell bald eagle feathers. When challenged by a dealer in such feathers, the court found no regulatory taking, since the dealer still had the feathers, though he could no longer sell them. The court explained that when a party owns a "bundle" of property rights, the "destruction of one strand" does not necessarily arise to a taking, even if the strand is the most profitable use of the property. Further, the court said anticipated future profits is a less compelling interest than other rights.

In Connolly v. Pension Benefit Guaranty Corp., the court determined that there was no regulatory taking when employers were required to increase their funding of a pension plan in excess of contractual obligations. "This interference with the property rights of an employer arises from a public program that adjusts the benefits and burdens of economic life to promote the common good and, under our cases, does not constitute a taking requiring government compensation."

With respect to the "distinct investment-backed expectations" factor, the court said employers had received notice that pension plans were subject to regulation, and that further requirements could be mandated.

Current proposals for a safe harbor would provide limited immunity for servicers from contract actions if the servicer modifies loans pursuant to government programs. The purpose of the legislation is to help resolve an crisis that is affecting the vitality of the entire nation, and not to simply readjust rights among private parties.

The interests of certain investors may be diminished, but their property is not eliminated. Thus, even though one "strand" of their interests may be affected, the bundle of their interests remains intact. Further, the interest is in "anticipated future profits," an interest that is "less compelling" than other property interests.

Finally, though investors certainly have a legitimate reason to rely on contractual rights governing the securitization of mortgages, the financial services industry is subject to extensive federal regulation. And even if a court found that the investors had a distinct investment-backed expectation that their contractual rights would not be changed by subsequent legislation, that would be only one of the three factors identified by the Supreme Court for consideration, and that single factor alone would not necessarily be decisive.

There should be no constitutional issue with a well-drafted legislative safe harbor.

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