Servicing Agreements Explained: Essential Definitions and Best Practices

What is a Servicing Agreement?

A servicing agreement is a contract between a financial institution (such as a bank, credit union, or private lender) and a third-party servicer that establishes the terms of service for managing various customer accounts. Servicing agreements exist for checking and savings accounts, securities accounts, and in our context, loan servicing – whether on the commercial side (lines of credit, term loans, mortgages, auto loans, etc.) and residential side (mortgage loans, home equity lines of credit, etc.). A standard servicing agreement is not one-size-fits-all; it is typically tailored to reflect the nature of the business relationship the financial institution maintains with its customers.
On the commercial side , the financial institution and servicer usually have significantly different priorities, duties, and expectations. The ultimate goal of the servicer is to get repaid for the amounts tied to the loan. The financial institution may have a more nuanced view, perhaps having an eye towards long-term customer relationships or other business considerations as to how accounts are handled. On the residential side, there are further considerations that must be made depending on the scope of regulatory oversight the financial institution and servicer are subject to, as well as considerations for how to provide effective communication between the institution and customer.

Key Elements of a Servicing Agreement

A servicing agreement or loan servicing agreement is usually comprised of the following key components:
Definition and Responsibilities of the Servicer. A servicing agreement commonly describes the role of the servicer in great detail so as to specify the exact responsibilities of the servicer. Various duties including the collection of monthly debt payments and the management of customer service related activities are normally included in this section.
Term of the Agreement. The length of time the servicer is expected to oversee the loan is generally included in the term section.
Compensation. The compensation section generally breaks down the fees for various activities and is commonly based on a monthly fee per loan or per customer managed. When structuring the compensation clause, it is essential to provide exact numbers if applicable, as well as examples of the conditions under which those numbers can be modified.
Performance Requirements and Performance Standards. A servicing agreement typically includes a clause or section dedicated to detailing the general performance requirements of the servicer as well as the specific performance standards expected of the servicer on a monthly basis. Performance standards are typically set at the beginning of the agreement and are sometimes tied to the number of years the servicer has been working with the lender or company.

Servicers: The Backbone of Financial Agreements

Since the recent housing crisis, loan servicers have become increasingly important in administering loans and collecting payments. But what exactly is a loan servicer? Loan servicers are financial institutions involved in the collection of mortgage payments and administration of mortgages from the time the loan closes until it is paid off. As part of their role, loan servicers also deal with any issues or concerns that borrowers may have in connection with their mortgage. Servicers are finally beginning to be recognized as a significant party to a mortgage that should receive treatment similar to creditors.
While the specific roles of loan servicers are often regulated by law, some of the general roles that servicers have traditionally been viewed as having are as follows:
• Principal Payments. Servicers apply principal payments received from the borrower to the principal balance of the Loan. Traditionally, principal payments are applied in the same priority as their order of maturity (e.g., principal payment due the next payment date gets applied to the oldest installment past due). However, federal regulations require that certain federal loans, such as those guaranteed by the U.S. Department of Housing and Urban Development, be allocated to principal in a manner that will pay off the mortgage as quickly as possible.
• Escrow. Servicers maintain escrow accounts, which they use to hold the portion of each monthly payment due from a borrower that is designated to pay property taxes, property insurance and any other amounts required to be paid from escrow. Where applicable, amounts are also placed in escrow to cover mortgage insurance premiums. (Although these amounts are referred to as "taxes," the term encompasses assessments that are collected by tax authorities, such as community facilities district (CFD) assessments, as well as other municipalities, such as school districts and fire districts, that impose ad valorem taxes. Although not often discussed in mortgage transactions, it is particularly important for payment of these assessments to be included in the scope of servicing obligations.)
• Taxes and Insurance. Servicers advance tax and insurance charges to protect the Lender’s interest. This process is called the "make-whole" process in which the Servicer advances mortgages expenses to ensure the consistency of encumbrances, making payments when expenses become due until a premium price is agreed upon or some other remedy is finalized. These payments are typically added back to the balance of the Loan with interest until the Loan is paid off. The Servicer collects from the Borrower in the form of monthly payments, typically through a monthly escrow like described above. All amounts received from the Borrower are allocated first to Servicing Expenses, then to interest, and finally to principal. The Servicer can also require the Borrower to reimburse the Servicer for all amounts advanced at the end of the Loan, which reimbursement can simply be subtracted from the amount to be remitted to the Lender.
• Investor Reporting. Servicers are usually required to provide periodic reports to the owner(s) of the obligation being serviced (e.g., investors in the pool that the loans were purchased into). These periodic reports must comply with the periodic reporting requirements applicable to the security. For example, federal regulations require that mortgage servicers make periodic disclosures to borrowers at the time they issue a periodic statement. Federal regulations also require that at the time a borrower’s loan is transferred, the servicer provide the borrower with the name and contact information of the new servicer.
From the perspective of a servicer, the most important part of a servicing agreement should be the treatment of servicing advances. Servicing agreements typically require that the owner of the obligation being serviced reimburse the servicer for all servicing advances made for the owner’s account. In the event that the servicing agreement does not require reimbursement for servicing advances, or permits selective reimbursement of only certain categories of servicing advances, the servicer should seek to revise the agreement.

Benefits of a Comprehensive Servicing Agreement

A well-crafted servicing agreement is in the best interest of both lenders and borrowers. A well-written servicing agreement can give clarity to both parties, ensuring that the loan is serviced properly so that it are more likely to be enforced correctly if the loan is in default.
Servicing lenders are primarily driven by compliance with law and minimizing risk. Servicing agreements often specify quality control standards and annual reviews of policies, procedures and disclosures. Effective QM and RESPA compliance as defined by the Dodd-Frank Act is critical for especially for the large lenders in order to minimize risk. Auditors will hold the lender responsible if the servicer fails to comply with any servicing requirements defined by the lender.
Effective loan administration directly impacts credit quality. Servicing issues can create a ripple effect that can have a negative impact on a lender’s capital adequacy, profitability and growth. For lenders whose regulatory authorities include capital adequacy requirements, assuring credit quality is essential. Poor loan administration can lead to increased risk, loss of income, adversely affect credit quality ratings or a downgrade, reduces capital, and limits growth.
A well-crafted servicing agreement will still ensure borrowers a degree of effective oversite because a lender will do periodic review of the servicer on the type of loan, borrower and other criteria. Third party audit requirements within a servicing agreement ensures accountability, which is what the Dodd-Frank Act was intended to achieve.

Common Issues and Solutions

Servicing agreements, like any other business contract, can sometimes lead to disputes between the parties over the way they are being interpreted or performed. This is generally unavoidable when you have potentially conflicting contract interpretations. When disputes arise, it is imperative that the parties work diligently to try and resolve the conflict in an amicable way. While any dispute resolution provision within the servicing agreement should be followed, sometimes it is necessary for the parties to involve lawyers even if that involves resolving the conflict outside of the realm of the servicing agreement’s dispute resolution process to have the disagreement resolved by a judge.
One of the most common reasons for disputes in servicing agreements is due to non-compliance by one of the parties. Obligations could include originator or document service timelines or payment schedules. Non-compliance is often caused by human error or misunderstanding of the requirements. However, non-compliance can sometimes result from an intentional act or willful neglect of said requirements. This can lead to termination of the servicing agreement if the actions are sufficiently egregious . It is crucial to follow the specified procedures to help avoid further conflict in, and potential termination of, the servicing agreement.
Another typical dispute with servicing agreements involves conflicting interpretations. Naturally, the interpretation of a servicing agreement can be in direct opposition to one another if not specifically clear. For example, if the jurisdiction specified in the servicing agreement does not specify whether actions must be filed in the state where the defendant resides, or the state where the property is, problems may arise over where legal claims should be initiated. To avoid this, be sure to specify exactly where actions should be taken, or wherever possible, eliminate jurisdiction issues by listing multiple jurisdictions as appropriate in the servicing contract language.
Servicing agreements can also be the subject of disputes between the servicer and its customers. For example, a customer may have a claim against the servicer for failing to comply with regulations that outline the minimum service standards. In addition, there may be violations of federal laws (i.e. RESPA) causing a dispute with the customer.

Legal Implications and Concerns

When it comes to servicing agreements, the legal requirements governing these contracts can be nuanced and complex. At their core, servicing agreements are subject to the same rules and regulations that apply to underlying loan agreements. Lenders who service loans—and those that outsource servicing duties to third-party providers—must ensure that they abide by all applicable state and federal laws in their performance of loan servicing services. Notably, this includes key statutes and regulations related to the Fair Debt Collection Practices Act (FDCPA), Real Estate Settlement Procedures Act (RESPA), and the Truth in Lending Act (TILA), among others.
The FDCPA is a federal statue that regulates the debt collection practices of third-party debt collectors. For both lenders and borrowers, the FDCPA outlines a wide range of prohibitions and requirements related to the treatment of debtors during the collection process. Specifically, the FDCPA restricts certain types of harassment and abuse of debtors, allows third-party debt collectors to communicate with debtors only at reasonable hours, and requires those debt collectors to refrain from threatening legal action against debtors that does not occur in good faith. Lenders are therefore advised to review the FDCPA when drafting servicing agreements to ensure compliance—and service providers must be aware of these provisions during debt collection activities.
The CFPB has indicated—in letters and speeches, among other places—that servicing loans is considered engaging in "debt collection"—and certain lenders have been required to hold special collections licenses as a result. Notably, creditors collecting their own debts do not have to comply with FDCPA requirements, but like actions by other creditors that originate in "debt collection," the CFPB may require creditors to hold status as licensed debt collectors under the FDCPA; whether or not a lending institution must abide by all FDCPA requirements (and obtain such a license) will depend on a variety of factors—including the extent to which the lending institution outsources its servicing activities and whether such third-party servicers are licensed debt collectors that comply with the FDCPA.
As we detailed in a prior blog post in this series, RESPA requires lenders and servicers to provide a variety of disclosures and provides an assortment of protections for borrowers. In general, RESPA seeks to ensure that borrowers obtain: As with the FDCPA, the CFPB has taken the position that servicing loans constitutes "debt collection" for purposes of RESPA requirements, and that certain loan servicers must therefore abide by RESPA and other HUD standards and requirements. Among other RESPA requirements, there are specific practices and disclosures that are required when servicers or lenders charge fees, such as disclosure of fees in writing. Servicing agreements must therefore comply with all relevant RESPA regulations.

Best Practices for Creating Servicing Agreements

Creating an effective servicing agreement requires extensive due diligence, a forward-looking approach, and a clear picture of the parties’ expectations and obligations. The parties should strive for clarity, while also remaining flexible so as to account for changing needs and conditions. One of the most important aspects of successful drafting is communication. The parties should work closely with each other to determine their specific goals and needs from the outset. To this end, the servicer and borrower should have periodic communications, either formally via meetings or informally via brief, quick discussions, to ensure that everyone is on the same page. The servicer should provide the borrower with its proposed business plan and timeline for servicing the loan. The borrower should also be ready to discuss its own borrowing needs and wants. With these fundamental goals in mind, the parties should have an allocation of responsibilities that is mutually agreeable and easy to understand. Additionally, they should run through numerous "what-if" scenarios, and flesh out the parties’ respective obligations under those circumstances. To accentuate the agreement’s clarity, the servicer should detail the services it will be providing. For example, if the servicer’s task list includes collecting payments, remitting payments to the lender, paying property taxes on behalf of the borrower, and other responsibilities, these items should be specifically enumerated in the servicing agreement. Similarly, the servicer and borrower should negotiate with regard to who will resolve potential issues with properties, and how they will do so. Some agreements may place the burden on the servicer, while others may seek to divide this responsibility up amongst the parties. At the end of the day, the parties should strive for consistency. From the very beginning, the servicer and borrower should set reasonable expectations that are then rigorously adhered to. The best way to do this is to document everything in writing, sticking both to a schedule for periodic communication and to a continuous feedback mechanism. The parties should also put a process in place for reviewing the servicing agreement on a regular basis to ensure that it remains current with regard to business needs and market conditions. As with the initial negotiation and drafting of the agreement, effective communication between the servicer and borrower is thus pivotal to a continuing relationship that yields benefits to both parties.

Current Trends and Developments in Servicing Agreements

Like every other sector of the commercial and consumer finance industries, the market for the origination and servicing, for balance sheet and securitized loans and lines of credit alike, has seen its share of activity over the past several months. While the vast majority of such transactions are still relatively straightforward, standard-issue arrangements, for people who closely observe the industry, there are several recent developments that are worth recognizing.
There continue to be greater numbers of strategic buyers for both origination and servicing functions, as entities attempt to complete 1+1=3 transactions that combine data, scale and client relationships. Industry insiders also report greater numbers of transactions that involve sellers with significant in-house origination or servicing staff who are "spun-off" in separate transactions where the staff are held out as a separate business line and reacquired where the originator or servicer is the purchaser or a majority shareholder. In both cases, the bulk of activity is occurring in the commercial finance sphere – where warehousing and monetization solutions in the form of joint ventures, licensing and joint ownership transactions are provided by larger banks, issuers and platforms to smaller players with an eye towards enabling the smaller player to use their capital more effectively to grow and expand as joint ventures and licensing transactions do not require REMIC compliant warehouses. Traditional arrangements continue to have significant transactional activity as well , though participants report that it is taking longer to consummate transactions because each party is reviewing the documents more carefully and that sellers are demanding greater substantive and procedural assurance of compliance from their prospective purchasers. In addition, issuers and banks continue to enter into repurchases and indemnities on their warehouse lines and funds and to hold waivers where servicers underwrite against outlined standards of conduct as a means of obtaining greater control over their experience under the pool and conduit agreements and providing the seller with the benefit of their own experience with counterparties in such transactions. Other arrangers have developed methodologies for providing control to the parties typically involved in such transactions which allow existing servicers to retain more control over such assets for longer in the process as well. In addition, parties continue to seek to craft creative, less-litigable indemnification and repurchase provisions as a means of providing more stability to their investments. These structures, long thought best suited for commercial transactions, are increasingly being applied to consumer sales as well.
While many of these developments are simply continuations of trends started years ago, there were two specific development worth mentioning. The first is the significant rise of the use by servicers and originators of third party software providers to help provide services or complete other tasks required of or expected from servicers, whether those tasks be collection, asset management or reporting. The second is the use of blockchain technology as means of record keeping, document storage and distribution, and assessment of credit risk by originators and servicers.