borrower sufficiently alleged fraud and other state law violations
stemming from option adjustable rate mortgage loans, and the lender's
alleged failure to disclose clearly and unambiguously that negative
amortization was a certainty if the borrowers made payments according to
the payment schedule provided to them by the lender.
A copy of the opinion is available at:
http://www.courtinfo.ca.gov/opinions/documents/G043716.PDF
Plaintiffs-Appellants ("Borrowers") executed nearly identical loan
documents to obtain "option adjustable rate mortgage loans" ("Option
ARMs") from Defendant-Respondent Home Loan Center, Inc. ("Lender"). The
material feature of the Option ARMs was that the Borrowers were permitted
to make low monthly payments for a certain period of time according to an
introductory "teaser" rate of interest. These low payments, however, were
insufficient to pay off the actual interest accruing on the principal.
The unpaid interest was added to the principal and resulted in "negative
amortization," meaning that as the principal amount increased, the
borrowers owed more to the Lender than they did on the date the loans were
made.
The Borrowers sued the Lender under state law for alleged fraudulent
omissions and alleged violations of California's Business and Professions
Code Section 17200 et seq. ("Section 17200"). In their complaint, the
Borrowers alleged that the Lender's loan documents supposedly failed to
adequately and accurately disclose that negative amortization would
definitely occur if the Borrowers paid only the amount set forth in the
payment schedule provided to them. The Borrowers further alleged that
they supposedly suffered damages for the loss of equity in their homes,
and that had the Lender disclosed the higher payment amounts required to
avoid negative amortization, they supposedly would not have entered into
the loan agreements.
The lower court sustained the Lender's demurrer without leave to amend and
dismissed the case. In the trial court's view, the loan documentation had
adequately described the nature of the Option ARMs and contained detailed,
repeated warnings about the risk of negative amortization. The Court of
Appeal reversed.
The appellate court first examined the loan documents attached to the
complaint: the promissory note; the three-page disclosure document
describing the Option ARM program for the loans; and the federal Truth in
Lending Disclosure Statement (TILDS) containing the payment schedule.
The Court specifically quoted certain provisions and disclosures from
those documents explaining the terms of the loans or indicating that the
loans were subject to negative amortization, including: (1) statements in
the promissory note setting forth the annual interest rate and indicating
that the borrowers would pay both principal and interest by making monthly
payments; (2) a conspicuous disclosure in the note stating that the
interest rate and monthly payment would change and that the "principal
amount to repay could be greater than the amount originally borrowed"; and
(3) disclosures explaining that the Option ARM "allows for negative
amortization," that interest rates have the "potential to increase . . ."
and that "the monthly payments may be insufficient to pay the interest
which is accruing . . . ."
The Borrowers had three payment options. They could choose to pay only
the "Minimum Monthly Payment" or they could make an amortizing payment
that covered all the interest owed for the month plus principal, or a
monthly interest-only payment to cover the full interest cost for the
month. The Court noted that the TILDS supposedly did not explain how the
initial payments in the payment schedule or the subsequent increases in
monthly payments were calculated, but that the amounts could be "reverse
engineered" by reference in part to the principal and interest rate
provisions in the note itself. The Court stated that "it is implicit in
the plaintiffs' payment schedule that negative amortization will occur if
plaintiffs were to remit only the monthly payment amounts set forth in the
payment schedule."
The Court then discussed the federal Truth in Lending Act ("TILA") and its
regulations, because it "provided the context for the disclosures made by
[the Lender]" and because the Lender claimed that its compliance with TILA
provided a complete defense to the Borrowers' state law claims. See 15
U.S.C. §1601 et seq.; 12 C.F.R. §226.1 et seq. (2010). The Court noted
among other things that TILA regulations require disclosures to be in a
"reasonably understandable form" that do not "obscure the relationship of
the terms to each other."
The Court found persuasive the reasoning in a number of federal court
decisions that addressed TILA and Option ARM forms and disclosures similar
to those in this case. Quoting Velasquez v. GMAC Mortgage Corporation,
605 F. Supp. 2d 1049, 1065, 1067 (C.D. Cal. 2008), the Court noted that
while the disclosures may be "literally accurate . . . [the Borrowers] may
be able to show that, when taken in conjunction with the disclosure in the
Note and the TILDS, [the program disclosure] is not clear and conspicuous
as required by TILA." In light of these decisions, the appellate court
concluded that it would be inappropriate to dismiss an action brought
under TILA at this stage of the proceedings, and rejected the Lender's
argument that "strict compliance with TILA provides a safe-harbor from
[the Borrowers'] claims," because the Lender may not have complied with
TILA.
The Court noted that a number of federal district courts that had
permitted similar TILA claims involving Option ARMs to proceed beyond the
motion to dismiss stage had also denied motions to dismiss state law fraud
and unfair business practices claims based on the same facts. The Court
explained that the Borrowers had satisfied the pleading requirements for
fraud by pleading each element with sufficient specificity.
With regard to the Borrowers' Section 17200 cause of action, the Court
noted that Section 17200 prohibits business practices that are "unlawful,"
"unfair," or "fraudulent" and that based on the Court's analysis of the
fraud claim, the Section 17200 claim had been adequately pleaded under the
"unlawful" and "fraudulent" prongs.
The Court also concluded that the Borrowers had sufficiently alleged
"unfair" business practices, as the payment schedule did not clearly
indicate that it was based on the low teaser rate. The Court further
observed that, although it may be difficult for the Borrowers to prove
they could not have avoided negative amortization completely, the
Borrowers "may show that they were unable to avoid some substantial
negative amortization" under their loans.
The Court also noted that to the extent that the "unfair" claim must be
tied to a specific statutory or regulatory provision, TILA and its
regulations provide "an adequate tether even though plaintiffs are not
directly relying on federal law . . . ." Finally, the Court also rejected
the Lender's argument that the Borrowers failed to adequately allege
standing and concluded that the Borrowers had met their burden by alleging
economic injury.
Ralph T. Wutscher
McGinnis Tessitore Wutscher LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
Direct: (312) 551-9320
Fax: (312) 284-4751
Mobile: (312) 493-0874
Email: RWutscher@mtwllp.com
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