Wraparound Regulation in Texas

Wraparounds are Complex

Wraparounds are complex, especially after extensive regulations were added to the Texas Finance Code in 2022. Wraps require professional-grade documentation starting with a custom wrap addendum to the earnest money contract. Accordingly, buyer and seller in a wraparound transaction should each have their own counsel. After the 2022 changes, the notion that an amateur (or even an experienced real estate broker) can effectively handle a wraparound without legal guidance is unrealistic.

Law Applicable to Residential Wraps

Law and rules applicable to residential wraparounds range across the Texas Finance Code, the Texas Property Code, the Safe Act (both federal and state versions), Dodd-Frank, rules made by the Texas Department of Savings and Mortgage Lending, regulations promulgated by the federal Consumer Financial Protection Bureau, and (of course) case law. If one is a real estate license holder, then the Real Estate License Act and TREC rules come into play. And, as is true with most consumer transactions, there is the Deceptive Trade Practices Act to contend with.

Finance Code Regulation of Wraparounds

The Texas Finance Code is at the center of wraparound regulation. TFC Chapter 159 is entitled “Wrap Mortgage Loan Financing” and broadly applies to all residential wraps (and all lenders and loan originators) unless it expressly says otherwise.

The TFC was significantly amended in 2022 to beef up regulatory coverage of wraparounds. Licensing and registration requirements for wrap sellers were added as were disclosure requirements, investigation and enforcement provisions, and an administrative penalty.

The licensing requirement is found in Section 159.051:

TFC Sec. 159.051. License or Registration Required

A person may not originate or make a wrap mortgage loan unless the person is licensed or registered to originate or make residential mortgage loans under Chapter 156, Chapter 157, or 342 [of the Finance Code] or is exempt from licensing or registration as provided under an applicable provision of those chapters.

Rules Implementing the Finance Code

The Department of Savings and Mortgage Lending (subject to the oversight and under the jurisdiction of the Texas Finance Commission) is charged with adopting and enforcing rules necessary for investigation and enforcement of wraparound law. TDSML rules may be found in Chapter 78 of the Texas Administrative Code and are posted on the secretary of state’s website.

Definition of a Wraparound Transaction

What qualifies as a wraparound transaction according to the TFC? Section 159.001(7) states that a wraparound mortgage loan is “a residential mortgage loan made to finance the purchase of residential real estate that will continue to be subject to an unreleased lien that attached to the residential real estate before the loan was made; and secures a debt incurred by a person other than the wrap borrower that was not paid off at the time the loan was made; and obligating the wrap borrower to the wrap lender for payment of a debt the principal amount of which includes the outstanding balance of the debt and any remaining amount of the purchase price financed by the wrap lender.” This definition is conventional and consistent our ordinary understanding of what constitutes a wrap.

Exemptions to Wraparound Regulation

A quick reading of the statute makes it clear that the Finance Code intends to target real estate investors who use wraparounds in selling a substantial number of single-family homes each year. TFC Section 159.003(4) exempts any owner of residential real estate who in any twelve consecutive-month period makes no more than three residential mortgage loans to purchasers of property for all or part of the purchase price of the residential real estate against which the mortgage is secured.

Note that this would include any form of seller financing, not just wraparounds (TFC Sec. 157.0121(c)(2) and 159.003(4)).

The Finance Code requirements do not apply to unimproved residential real estate (defined as residential real estate on which a dwelling has not been constructed) so long as the holder of [the] unreleased lien has consented to the sale of the residential real estate. . .” (TFC Sec.159.002 (a) and (b)).

The statute does not apply to “a sale of residential real estate that is the wrap lender’s homestead” (TFC Sec. 159.002(b)(2)).

Lenders and loan originators are exempt from the rules if they are federally-regulated lenders, non-profits, licensed mortgage brokers, or Section 501(c)(3) organizations. Employees of these organizations are also exempt.

Combining Entities Does Not Avoid the Rules

The statute anticipated that creative wrap seller-lenders and their attorneys would attempt to run around the de minimis rule by setting up entities for that purpose, so it provides specifically that one may not exceed the number of seller-financed transactions (including wraps) allowed under the de minimis rule by utilizing an LLC or other entity as a front for doing additional wraps. The rules apply in a combined way to an individual as well as that person’s affiliated entities: “In determining eligibility for an exemption under Subsection (a-1)(3), two or more owners of residential real estate are considered a single owner for the purpose of computing the number of mortgage loans made within the period specified by that subdivision if any of the owners are an entity or an affiliate of an entity, including a general partnership, limited partnership, limited liability company, or corporation. . .” (TFC Sec. 157.0121(f) and 159.003(b)).

NOTICES REQUIRED OF WRAP SELLERS

Notices under the Property Code and the Finance Code are designed to alert wraparound buyers that there is an existing unpaid lien against the property and to warn of potential insurance coverage issues.

Required Seller Notice under Prop. Code Sec. 5.016

Property Code Section 5.016 is entitled “Conveyance of Residential Property Encumbered by Lien.” Since this is exactly what wraparounds do, this statute is directly applicable. Property Code Section 5.016 requires that the seller give a notice that includes the following warning:

WARNING: ONE OR MORE RECORDED LIENS HAVE BEEN FILED THAT MAKE A CLAIM AGAINST THIS PROPERTY AS LISTED BELOW. IF A LIEN IS NOT RELEASED AND THE PROPERTY IS CONVEYED WITHOUT THE CONSENT OF THE LIENHOLDER, IT IS POSSIBLE THE LIENHOLDER COULD DEMAND FULL PAYMENT OF THE OUTSTANDING BALANCE OF THE LIEN IMMEDIATELY. YOU MAY WISH TO CONTACT EACH LIENHOLDER FOR FURTHER INFORMATION AND DISCUSS THIS MATTER WITH AN ATTORNEY.

The notice must: (1) give seven days’ notice to the buyer before closing that an existing loan will remain in place; and (2) inform the buyer that buyer has this same seven-day period in which to rescind the earnest money contract without penalty. The same notice must be given to the lender. These notices are all the obligation of the seller. There are no notice requirements imposed on buyers by Section 5.016.

Contents of the Section 5.016 Notice

Section 5.016 notices must include:

(1) an identification of the property;

(2) the name, address, and phone number of each wrapped lienholder;

(3) the amount of debt that is secured by each existing lien;

(4) a summary of the terms of any contract or law under which the existing loan to be wrapped is secured including the interest rate, the amount of monthly payments, and the account number;

(5) the details of any insurance policy relating to the property including the name of the insurer and insured as well as the amount for which the property is insured; and

(6) the amount of the property taxes. It must also be stated clearly whether or not the existing lienholder (the wrapped lender) has consented to the wraparound.

Note that lender consent is not required. Lender notices, often sent to the loan servicer, generally produce no response.

The Department of Savings and Mortgage Lending has promulgated a model disclosure statement that may be found on the agency’s website.

Exceptions to Property Code Notice Requirements

Exceptions to the notice requirements are made for certain transfers including from one co-owner or spouse to the other. Property Code Section 5.016(c)(10) also provides an exception to the notice requirement when “the purchaser obtains a title insurance policy insuring the transfer of title to the real property.” Thus if you close at a title company you may dispense with seven-day notices. Professional investors (those who have “purchased, conveyed, or entered into contracts to purchase or convey real property four or more times in the preceding 12 months”) need not be given the notice (Prop. Code Sec. 5.016(c)(11)).

The buyer’s cancellation remedy for seller’s failure to give the seven-day notice is an exclusively pre-closing remedy. There is no right of rescission on this basis after closing.

Seller Notice Requirement under the Finance Code

Under Finance Code Section 159.101, a wrap seller-lender must, on or before the seventh day before the wrap mortgage loan agreement is entered into, provide to the wrap borrower a separate written disclosure statement in at least 12-point type warning that insurance coverage can be problematic. This notice requirement is in addition to the one required by Property Code Section 5.016. The statutory wording is as follows:

NOTICE REGARDING PROPERTY INSURANCE: ANY INSURANCE MAINTAINED BY A SELLER, LENDER, OR OTHER PERSON WHO IS NOT THE BUYER OF THIS PROPERTY MAY NOT PROVIDE COVERAGE TO THE BUYER IF THE BUYER SUFFERS A LOSS OR INCURS LIABILITY IN CONNECTION WITH THE PROPERTY. TO ENSURE THE BUYER’S INTERESTS ARE PROTECTED, THE BUYER SHOULD PURCHASE THE BUYER’S OWN PROPERTY INSURANCE. BEFORE PURCHASING THIS PROPERTY, YOU MAY WISH TO CONSULT AN INSURANCE AGENT REGARDING THE INSURANCE COVERAGE AVAILABLE TO YOU AS A BUYER OF THE PROPERTY.

The notice required by Finance Code Section 159.101 must be given to the wraparound buyer-borrower on or before the seventh day before the wrap mortgage loan agreement is entered into (interpreted to mean the date of closing). It must be dated and signed by the wraparound borrower when the wrap borrower receives the statement.

There is also a foreign language requirement. If negotiations preceding execution of the wrap closing documents are conducted primarily in a language other than English, the wrap seller-lender must provide the required disclosures in the language to the wrap buyer-borrower (TFC Sec. 159.102).

Exceptions to Finance Code Notice Requirements

Finance Code seller-notice requirements do not apply to:

(1) unimproved residential real estate (i.e., residential real estate on which a dwelling has not yet been constructed) so long as the holder of the unreleased note and lien has consented to the sale of the residential real estate (TFC Sec.159.002 (a) and (b));

(2) a sale of residential real estate that is the seller-lender’s lender’s homestead (TFC Sec. 159.002(b)(2)).

(3) “an owner of residential real estate if the owner does not in any 12-consecutive-month period make, or contract with another person to make, more than three wrap mortgage loans to purchasers of the property for all or part of the purchase price of the residential real estate against which the mortgage is secured” (TFC Sec. 159.003(4)).

RIGHTS OF WRAP BUYER-BORROWERS

There are a number of rights and remedies granted to a buyer-borrower by Finance Code Section 159.104. Note that these rights apply only to wrap loans made for the purchase of residential real estate to be used as the buyer-borrower’s residence (TFC Sec. 159.201).

Disclosures Timely Provided—Right of Recission

If the required disclosures are timely given and received prior to closing, the wrap buyer-borrower may rescind the transaction not later than the 7th day after the date of receipt of the disclosure statement.

Failure to Provide Disclosures—Right of Recission before Closing

If the required disclosures are not given and received before closing, the wraparound borrower may rescind the wrap mortgage loan agreement and the related purchase agreement at any time by providing the wrap lender notice of rescission in writing.

Failure to Provide Disclosures—Right of Recission after Closing

If the required disclosures are given and received by the wrap buyer-borrower after closing (but before any notice of recission is given) then the wrap buyer-borrower may rescind the wrap transaction in writing on or before the 21st day after the date of receipt of the disclosures. The wrap seller-lender must pay to the wrap buyer-borrower as damages for noncompliance the sum of $1,000 plus any reasonable attorney’s fees incurred by the wrap buyer-borrower.

Recission Amounts Due to the Buyer-Borrower

Upon recission, and not later than the 30th day after the date of recission, the wrap buyer-borrower is entitled to the return of any earnest money, escrow amounts, down payment, and other fees or charges that have been paid to the wrap seller-lender. TFC Sec. 159.101(d).

Avoidance of Recission by the Seller-Lender

Notwithstanding the above, the wrap seller-lender may avoid recission if not later than the 30th day after receiving the recission notice, the wrap seller-lender entirely pays off the wrapped loan (no mention is made of providing or recording a release of lien); pays any taxes due on the property; and pays to the wrap buyer-borrower $1,000 plus reasonable attorney’s fees. The wrap seller-lender is required to provide evidence of the foregoing actions. TFC Sec. 159.104(e)(1-4).

Tolling of the Statute of Limitations

If a wrap seller-lender fails to provide the disclosure statement as required by Section 159.101 or fails to provide disclosures in the language required by Section 159.102, the limitations period applicable to any cause of action of the buyer-borrower against the wrap seller-lender arising out of the wrap seller-lender’s violation in connection with the wrap transaction is tolled until the 120th day after the date the required disclosure statement is provided. TFC Sec. 159.103.

On the date when all funds are returned to the wrap buyer-borrower, the buyer-borrower shall re-convey the property to the wrap lender or its designee and surrender possession within 30 days (TFC Sec. 159.104(d)). This provision also has the effect of stipulating the date on which the re-conveyance must be effective.

Right of Buyer-Borrower to Deduct

The Finance Code allows the wrap buyer-borrower a right to deduct in the event that the wrapped lender is not being timely paid. TFC Sec. 159.202 provides that the “wrap borrower, without taking judicial action, may deduct from any amount owed to the wrap lender under the terms of the wrap mortgage loan: (1) the amount of any payment made by the wrap borrower to an obligee of a debt described by Section 159.001(7)(A)(ii) to cure a default by the wrap lender caused by the lender’s failure to make payments for which the lender is responsible under the terms of the wrap mortgage loan; or (2) any other amount for which the wrap lender is liable to the wrap borrower under the terms of the wrap mortgage loan.”

This provision is meaningful only if the wrap buyer-borrower has a means of ascertaining the status of the wrapped loan (the online login information, for instance). Otherwise, the wrap buyer-borrower may not be aware of any default issues with the wrapped loan until the property is posted for foreclosure by the wrapped lender—or worse, when a constable serves a forcible detainer (eviction) action after foreclosure has occurred.

Interestingly, the right to deduct provision does not require the wrap buyer-borrower to apply deducted funds to the cure of a default under the wrapped mortgage loan. Assuming, however, that the wrap buyer-borrower does so, then the right to deduct provision becomes the equivalent of a right to cure for purposes of avoiding foreclosure on the home.

Fiduciary Duty of Seller-Lender

The collection of payments from a wrap buyer-borrower is subject to a fiduciary duty owed by wrap seller-lender to the wrap buyer-borrower. Finance Code Sections 159.151 and 159.152 state: “A person who collects or receives a payment from a wrap borrower under the terms of a wrap mortgage loan holds the money in trust for the benefit of the borrower. . . . A person who collects or receives a payment from a wrap borrower under the terms of or in connection with a wrap mortgage loan owes a fiduciary duty to the wrap borrower to use the payment to satisfy the obligations of the obligee under each [wrapped loan as well as] the payment of taxes and insurance for which the wrap lender has received any payments from the wrap borrower.”

It has long been a concern of residential wrap buyer-borrowers that the wrap seller-lender may not use monthly payments on the wrap note to discharge the underlying wrapped lien. The duty of the wrap seller-lender to make payments on the underlying loan is usually taken for granted as if it were a negligible term—when it is in fact at the very core of the wraparound relationship. However, absent a provision in a wrap agreement, the wrap seller-lender previously had no express duty in this area. The 2022 amendments to the Finance Code attempt to cure this problem by adding the right to deduct.

Query: Why not just expressly state that the wrap seller-lender has an affirmative duty to use the wrap buyer-borrower’s monthly payments for the purpose of paying down the wrapped loan? Or did the statute drafters believe that imposing a fiduciary duty would cover this issue? In any case, a well-drafted wraparound agreement will make this duty clear.

Consumer Waivers Prohibited

Any purported waiver of a wrap buyer-borrower’s rights or purported exemption of a person from liability for violation of the above rules (no matter how cleverly worded) is void under TFC Sec. 159.107:

A person who is a party to a residential real estate transaction may not evade the application of this subchapter by any device, subterfuge, or pretense, and any attempt to do so is void and a deceptive trade practice. . . .

The tie-in with the DTPA gives this provision extra power since the DTPA broadly prohibits “any unconscionable act or practice”—something easily found by jurors when they want to punish a defendant (Bus. & Com. Code Sec. 17.50 et seq.).

When combined, the right to deduct, the lender’s fiduciary duty, and the no-waiver provision go a long way toward redressing the disparity of rights and power that has previously been inherent in Texas wraparound transactions.

Lawsuit Remedy of Buyer-Borrower

If wrap provisions of the Finance Code are violated, a wrap buyer-borrower may bring a lawsuit against the wrap seller-lender to:

(1) obtain declaratory or injunctive relief to enforce Code provisions;

(2) recover any actual damages suffered by the wrap buyer-borrower as a result of the violation; or

(3) obtain other remedies by using the Deceptive Trade Practices Act, which is a very significant weapon in the hands of a competent plaintiffs’ attorney.

The wrap buyer-borrower who prevails in a suit against the wrap seller-lender may recover court costs and reasonable attorney’s fees (TFC Sec. 159.106).

INVESTIGATION BY TDSML

Complaint to TDSML

An additional remedy is the ability of a wrap buyer-borrower to report an alleged violation to the Department of Savings and Mortgage Lending. The agency may then launch an investigation, although this remedy is limited by Section 159.251 to registered wrap lenders—a puzzling and unfortunate limitation.

The investigatory process is outlined in Section 159.252(a):

TFC Sec. 159.252. Inspection; Investigation

(a) The [Finance Commissioner] may conduct an inspection of a wrap lender registered under Chapter 158 as the commissioner determines necessary to determine whether the wrap lender is complying with that chapter and applicable rules. The inspection may include an inspection of the books, records, documents, operations, and facilities of the wrap lender. The commissioner may share evidence of criminal activity gathered during an inspection or investigation with any state or federal law enforcement agency.

(b) For reasonable cause, the commissioner at any time may investigate a wrap lender registered under Chapter 158 to determine whether the lender is complying with that chapter and applicable rules.

(c) The commissioner may conduct an undercover or covert investigation only if the commissioner, after due consideration of the circumstances, determines that the investigation is necessary to prevent immediate harm and to carry out the purposes of Chapter 158.

(d) The finance commission by rule shall provide guidelines to govern an inspection or investigation under this section, including rules to: (1) determine the information and records of the wrap lender to which the commissioner may demand access during an inspection or investigation; and (2) establish what constitutes reasonable cause for an investigation.

(e) Information obtained by the commissioner during an inspection or investigation under this section is confidential unless disclosure of the information is permitted or required by other law.

(f) The commissioner may share information gathered during an investigation under this section with a state or federal agency. The commissioner may share information gathered during an inspection with a state or federal agency only if the commissioner determines there is a valid reason for the sharing.

(g) The commissioner may require reimbursement of expenses for each examiner for an on-site examination or inspection of a registered wrap lender under this section if records are located out of state and are not made available for examination or inspection by the examiner in this state. The finance commission by rule shall set the maximum amount for the reimbursement of expenses authorized under this sub-section.

Information obtained during an investigation may be shared with “a state or federal agency” (TFC Sec. 159.252(f)). The clear implication here is that the Commission may make criminal referrals to state and federal prosecutors. This continues the decades-long trend in U.S. law of effectively criminalizing offenses that were previously entirely civil in nature. As Elon Musk has suggested, everything seems to be a felony now.

FINANCE COMMISSION ENFORCEMENT

Subpoena Power

During an investigation, a subpoena may be issued requiring a person to give a deposition, produce documents, or both. If a person disobeys the subpoena, refuses to appear for a deposition, or refuses to testify, the Department of Savings and Mortgage Lending may turn to the Travis County District Court for assistance, specifically a court order requiring the person to obey the subpoena, testify, or produce documents.

This provision opens an important door to enforcement by means of judicial contempt (TFC Sec. 159.253(b)). Although contempt in this event would be a civil and not a criminal matter, a real estate investor sitting in jail could be forgiven for not appreciating the difference.

Cease and Desist Order

If there is reasonable cause to believe that a wrap lender or wrap mortgage loan originator is in violation, the Finance Code provides for an administrative remedy:

TFC Sec. 159.301. Cease and Desist Order

(a) [The Finance Commissioner] may issue without notice and hearing an order to cease and desist from continuing a particular action or an order to take affirmative action, or both, to enforce compliance with this chapter. (b) An order issued under Subsection (a) must contain a reasonably detailed statement of the facts on which the order is made. If a person against whom the order is made requests a hearing, the commissioner shall set and give notice of a hearing before the commissioner or a hearings officer. The hearing shall be governed by Chapter 2001, Government Code.

(b) . . . based on the findings of fact, conclusions of law, and recommendation of the hearings officer, the [Finance] commissioner by order may find a violation has occurred or not occurred.

(c) If a hearing is not requested under Subsection (b) on or before the 30th day after the date on which an order is made, the [Finance Commissioner’s] order is considered final and not appealable.

(d) The [Finance] commissioner, after giving notice and an opportunity for hearing, may impose against a person who violates a cease and desist order an administrative penalty in an amount not to exceed $1,000 for each day of the violation. In addition to any other remedy provided by law, the commissioner may institute in district court a suit for injunctive relief and to collect the administrative penalty. A bond is not required of the commissioner with respect to injunctive relief granted under this sub-section.

Exemptions from Enforcement

Finance Code Section 180.003 provides that certain persons are exempt from investigation and enforcement by the Finance Commission:

(1) a registered mortgage loan originator when acting for a licensed entity;

(2) an individual who offers or negotiates terms of a residential mortgage loan on behalf of an immediate family member;

(3) a licensed attorney who negotiates the terms of a residential mortgage loan on behalf of a client as part of the attorney’s representation of the client, unless the attorney either takes a residential mortgage loan application or offers or negotiates the terms of the residential mortgage loan;

(4) an individual who offers or negotiates terms of a residential mortgage loan secured by lien on the individual’s residence;

(5) an owner of residential real estate who in any 12-consecutive-month period makes no more than three seller-financed residential mortgage loans; and

(6) an owner of a dwelling who in any 12-consecutive-month period makes no more than three seller-financed residential mortgage loans.

The same rule against combinations applies as elsewhere in the statute, i.e., “two or more owners of residential real estate are considered a single owner for the purpose of computing the number of mortgage loans made within the period specified by that subdivision if any of the owners are an entity or an affiliate of an entity, including a general partnership, limited partnership, limited liability company, or corporation. . . .” (TFC Sec. 180.003(d)). Accordingly, setting up additional entities solely for the purpose of evading Finance Code transactional limitations is to no avail.

THE SAFE ACT AND DODD-FRANK
AS APPLIED TO WRAPAROUNDS

SAFE Act and T-SAFE

Since wraps are a form of seller financing, any law that applies to seller financing applies to wraps. Federal laws on this subject include the SAFE Act (or T-SAFE as it is implemented in Texas) and Dodd-Frank.

The SAFE Act (TFC Sec. 180.001 et seq.) imposes a licensing requirement on certain types of seller financing extended by persons who are regularly engaged in offering such financing in the sale of residences. A seller-lender is required to be licensed as an RMLO if the property is not the seller’s homestead and/or if the sale is not to a family member. So, if the property is a rental house (i.e., not the seller’s homestead) that is being sold to a non-family member, then the seller is required to have an RMLO license, which requires training, a background check, and an exam. This licensing rule applies only to residential wraps and is not applied to persons making three or fewer seller-financed residential loans in a year.

Dodd-Frank

Dodd-Frank (Title XIV of the federal Mortgage Reform and Anti-Predatory Lending Act, 15 U.S.C. Sec. 1639 et seq.) overlaps the SAFE Act in regulatory intent and effect. It requires that a seller-lender in a residential seller-financed transaction (including wraps) determine at the time credit is extended that the buyer-borrower has the ability to repay the loan (the ATR rule). The ATR rule obligates the seller to investigate the buyer-borrower’s credit history, current and expected income, financial obligations, debt-to-income ratio, employment status, and the like in order to make a determination that a buyer-borrower has the reasonable ability to repay.

Dodd-Frank provides for a de minimis exception for persons doing no more than three owner-financed transactions per year (so long as the seller-lender is not in the building business)—but (1) the seller must take thorough steps to determine that the buyer has a reasonable ability to repay; and (2) the note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime caps. CFPB Reg. Sec. 1026.36(a)(4). In its comments to the rule, CFPB states that “A person in good faith determines that the consumer to whom the person extends seller financing has a reasonable ability to repay the obligation if the person complies with Sec.1026.43(c) [by considering] evidence of the [buyer-borrower’s] current or reasonably expected income.” Evidence of compliance with the ATR rule should always be retained in the seller’s file as a defensive measure against potential future lawsuits.

Dodd-Frank is a hugely complex law and continues to undergo interpretation and rule-making by the Consumer Financial Protection Bureau (CFPB). These rules are a challenge to understand, interpret, and apply—even for experienced attorneys who focus in this area.

The Future of Wraparounds

Wrap transactions may still be done in Texas after the 2022 law changes, but carefully and with attention to both the statute and the rules designed to enforce it. More such rules will inevitably be released in the years to come, making this a challenging area for all involved—whether they be real estate investors. lenders, title companies, or attorneys.