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.