Tuesday, December 18, 2012

Common Law Fraud as a class action may be the answer to Negative Amortization Loans

Note that Dan Schecter from Loyola Law School's commentary.

Jordan v. Paul Financial, LLC, 2012 Westlaw 3647759 (N.D. Cal.):

            Facts:  Various residential borrowers executed notes secured by mortgages.  Under the terms of the documents, the borrowers were permitted to make very low initial payments.  The Truth in Lending Disclosure Statement ("TILDS”) given to each borrower failed to state that if the borrowers made payments pursuant to the payment schedule set out in the documentation, the principal on the loan would increase over time and that the borrowers would lose equity in their homes with each payment, a process sometimes called "negative amortization."  After the origination of the transactions, the originating lender would sell the loans to an assignee, pursuant to a pre-existing master purchase agreement.
            Eventually, the borrowers brought a class action against the originating lender and its assignee, claiming that the lender and the assignee had committed fraud by failing to tell the borrowers about the negative amortization.  The assignee brought a motion for summary judgment, arguing that the documents were not misleading and that it could not be held liable for the conduct of the originator.  The borrowers cross-moved for class certification.   
            Reasoning: The court denied the assignee's motion for summary judgment:
[S]imply providing technically accurate disclosure does not excuse the potentially inadequate or misleading character of other disclosures, or lessen the resulting potential for confusion . . . .  It is of course possible that a buyer would pay more each month than the schedule provided for in the TILDS, thus avoiding negative amortization. But the Court will not turn a blind eye to the fact that the document at issue here is, as far as the Court can tell, designed to mislead. Nowhere in the TILDS, or the Note for that matter, is there any revelation of the fact that the interest rate is certain to sharply increase after just 30 days. Nor does the TILDS contain any indication that following the payment schedule provided will unquestionably lead to negative amortization . . . . [W]ere one to follow the TILDS payment schedule, after 59 months of payment, the borrower would owe 110% of the original principal.

            The court went on to hold that the assignee could be held liable for "aiding and abetting" the loan originator's fraudulent conduct because the assignee knowingly rendered "substantial assistance" to the originator.  The assignee argued that it did not have actual knowledge of the fraud, but the court disagreed:

[The assignee] argues that in reviewing the loan documents it was simply engaged in typical due diligence. However, . . . [the assignee's] due diligence may well have imparted the knowledge required to establish aiding and abetting.

            Finally, the court held that because the assignee's funding was critical to the loan originator, the assignee could be held liable for having provided "substantial assistance" to the originator:

[The assignee] was one of [the originator's] major secondary market purchasers, as well as the affiliate to a major warehouse lender. Hundreds of millions of dollars, if not billions, flowed through [the originator] because of [the assignee's] involvement.

            The court went on to certify the class.

            Author’s Comment:  Note that this is not simply a Truth in Lending Act case; instead, the borrowers (acting as a class) assert that the loan originators committed common law fraud and that the mortgage purchasers are liable as aiders and abettors.  Naturally, one's sympathy is with the borrowers, who were undoubtedly defrauded by loan originators who concealed the inevitable negative amortization of these mortgages.  But to extend fraud liability to the purchasers on the secondary market would greatly expand the scope of potential defendants, making these "toxic assets" doubly dangerous.

            On one hand, this decision might be worrisome to anyone holding interests in bundles of residential mortgages.  On the other hand, though, perhaps this decision can be restricted to its facts: it might only affect assignees with direct contact with the loan originator, rather than those who purchase residential mortgages through intermediaries.  In that case, although many large institutions could face fraud liability, tertiary or remote investors in mortgage-backed obligations should not be too concerned.

Dear Readers:  This is an important case with commentary by Professor Dan Schechter, Loyola School of Law.  Note his commentary about how the courts may be angry with the banks for their faux pas, but they are also growing weary of homeowners who are unwilling to pay.  Keep this in mind.

Best to you all:

Shuster vs. BAC Home Loans Servicing, LP, 2012 Westlaw – – (Cal.App.):

            Facts:  Two individuals borrowed $670,000 to purchase a home.  The deed of trust named Mortgage Electronic Registration Systems, Inc. ("MERS") as the beneficiary, but the deed of trust failed to name a trustee.

            Four years later, the borrowers defaulted.  MERS named a substituted trustee, which recorded a notice of default.  Following a nonjudicial foreclosure, the borrowers filed a complaint for quiet title, arguing that the deed of trust was a "mortgage" requiring judicial foreclosure, rather than nonjudicial foreclosure, since it failed to name a trustee.  The trial court ruled in favor of the lender, and the appellate court affirmed.    

            Reasoning:  The court noted that although this was an issue of first impression in California, courts in other states have uniformly held that the omission of a trustee does not preclude nonjudicial foreclosure.  On appeal, the borrowers argued that a conveyance that fails to name the grantee is void.  But the court rejected that argument:

A grantee is not the same as a trustee.  The character of "title" provided by a grant deed differs substantially from that provided by a deed of trust.  A grant deed conveys a fee simple title to the grantee for all purposes . . . . In contrast, a trustee under a deed of trust "carries none of the incidents of ownership of the property, other than the right to convey upon default . . . ."

            The court went on to hold that the foreclosing party did not have to produce the original promissory note and that the borrowers' failure to tender the balance due stripped them of standing to challenge the foreclosure sale.  The court concluded with the following observation:

We are mindful that foreclosures are a far too frequent occurrence in today's difficult financial times.  But the hardship must not become a haven for those who, as here, do not appear to make any good faith effort to resolve the issue but, instead, seek shelter in minor ministerial omissions or speculative acts that neither misled nor prejudiced them.

            Author’s Comment: This is almost certainly the right result.  If the deed of trust had utterly failed to name a beneficiary, that would have been more analogous to a grant deed that names no grantee.  But a trustee under a deed of trust is nothing like a grantee under a grant deed.  In fact, a trustee under a deed of trust is something less than a true trustee.  See Stephens, Partain & Cunningham v. Hollis, 196 Cal.App.3d 948, 955, 955 242 Cal.Rptr. 251, 255 (1987):  "Just as a panda is not an ordinary bear, a trustee of a deed of trust is not an ordinary trustee." The Stephens court in footnote 4 speculated: "With luck, this passage will end up as the following headnote in some legal digest: 'Trustee under deed of trust held to be panda bear.'”  Although I can't quite fulfill the court's prediction, it seems that a trustee under a deed of trust is an odd creature, one that (in this case) magically arose like a Phoenix from the empty ashes of the blank trust deed.

            Taking a step back, however, one has to ask: how could any lender ever draft and record a deed of trust without naming any trustee?  Admittedly, it is very easy to change trustees and to substitute one for another.  But it would seem obvious that the transaction should begin with someone nominally occupying that role.  The court rescued the transaction from this defect, but it should never have happened in the first place.

            The court's world-weary observation about borrowers who "seek shelter in minor ministerial omissions" is telling:  although the courts are disgusted with the financial industry's shoddy practices, they are also losing patience with borrowers who cannot pay and who simply seek to delay the inevitable.