After the great real estate implosion, lenders have been very busy, attempting to justify a number of questionable practices and products. One such loan product, the Option ARM, has been challenged in state and federal courts. Option ARM loans are complex forms of adjustable rate loans that generally include several payments options during the early years of the loan. One payment option includes the ability to make a "minimum" payment for several years. However, many Option ARM loan minimum payments are insufficient to pay accruing interest after an initial "teaser" interest rate that is very low. Once the "teaser" rate period expires, the unpaid interest is added onto the loan, increasing the principal balance owed on the loan (negative amortization). Because of their complexity, clear disclosures to borrowers are essential. In Boschma v. Home Loan Center, Inc. (August 10, 2011), the Court of Appeal (Fourth Appellate District, Division Three) held that a complaint alleging a lender's failure to disclose that negative amortization would definitely occur (instead describing that scenario as merely possible), was sufficient to state violations of the UCL and common law fraud.
The Court described the claims of the Second Amended Complaint:
The gravamen of plaintiffs' operative complaint is that defendant failed to disclose prior to plaintiffs entering into their Option ARMs: (1) "the loans were designed to cause negative amortization to occur"; (2) "the monthly payment amounts listed in the loan documents for the first two to five years of the loans were based entirely upon a low 'teaser' interest rate (though not disclosed as such by Defendants) which existed for only a single month and which was substantially lower than the actual interest rate that would be charged, such that these payment amounts would never be sufficient to pay the interest due each month"; and (3) "when [plaintiffs] followed the contractual payment schedule in the loan documents, negative amortization was certain to occur, resulting in a significant loss of equity in borrowers' homes, and making it much more difficult for borrowers to refinance the loans [because of the prepayment penalty included in the loan for paying off the loan within the first three years of the loan]; thus, as each month passed, the homeowners would actually owe more money than they did at the outset of the loan, with less time to repay it."
Slip op., at 13. The Court began its analysis by explaining what was not at issue in the case at this time:
It is important to demarcate the boundaries of this dispute. The following is not at issue in this case: (1) should it be legal to offer Option ARMs to typical mortgage borrowers; and (2) should it be legal to utilize "teaser" ("discounted") interest rates (here 1.25 percent for the first month of a 30 year loan), which bear no relation to the actual cost of credit? Our only concern in this case is whether plaintiffs stated a cause of action under state law based on defendant‘s allegedly misleading, incomplete, and/or inaccurate disclosures in the Option ARM documents provided to plaintiffs.
Slip op., at 15. The Court then observed that no California state court had addressed the exact issues presented in the case. However, the Court noted that a number of federal courts had examined similar issues.
The Court began by addressing the Defendant's contention that strict compliance with TILA provided it with a safe harbor of sorts:
A string of cases (involving strikingly similar Option ARM forms/disclosures to those used in the instant case) have held that a borrower states a claim for a violation of TILA based on, among other disclosure deficiencies, the failure of the lender to clearly state that making payments pursuant to the TILDS payment schedule will result in negative amortization during the initial years of the loan.
Slip op., at 18. The Court concluded that, since the allegations could support a cause of action for TILA violations, it would be nonsensical to dismiss the claims at this stage, based on a claim of compliance with TILA disclosure obligations. Note: There was no TILA claim asserted in this action, only UCL and fraudulent concealment claims.
Next, the Court considered the state law fradulent concealment claims. The Court began its discussion by citing a number of federal cases that allowed state law claims to proceed along with TILA claims. The Court then turned to the sufficiency of the fraud pleading. The Court found that the failure to disclose the exceedingly low teaser rate adequately was a sufficient omission to suppor the fraudulent concealment claim: "The teaser rate creates an artificially low (compared to the actual cost of credit) initial payment schedule and guarantees that the actual applicable interest rate (after the first month of the loan) will exceed the interest rate used to calculate the payment schedule for the initial years of the loan." Slip op., at 24.
Turning to the UCL, the Court found that the allegations were sufficient to support a UCL under all three prongs. The "unfair" prong discussion was the most interesting of the three:
As noted above in our discussion of damages, it may be difficult for plaintiffs to prove they could not have avoided any of the harm of negative amortization — they could have simply paid more each month once they discovered their required payment was not sufficient to pay off the interest accruing on the loan. But plaintiffs may show they were unable to avoid some substantial negative amortization. And we see no countervailing value in defendant's practice of providing general, byzantine descriptions of Option ARMs, with no clear disclosures explaining that, with regard to plaintiffs' particular loans, negative amortization would certainly occur if payments were made according to the payment schedule. To the contrary, a compelling argument can be made that lenders should be discouraged from competing by offering misleading teaser rates and low scheduled initial payments (rather than competing with regard to low effective interest rates, low fees, and economically sustainable payment schedules). Finally, to the extent an "unfair" claim must be "tethered" to specific statutory or regulatory provisions, TILA and Regulation Z provide an adequate tether even though plaintiffs are not directly relying on federal law to make their claims.
Slip op., at 29.
Fun fact: the Court cited Kwikset when rejecting the Defendant's contention that the Plaintiffs did not adequately allege standing under the UCL.
Disclosure: J. Mark Moore of Spiro Moss argued this matter before the Court of Appeal and contributed significantly to the briefing on appeal.
Since Bank of America etc. Assn. v. Pendergrass, 4 Cal. 2d 258, 263 (1935) (Pendergrass), California Courts have, to various degrees, excluded evidence of fraud when the fraud is directly contrary to the terms of a written agreement. In Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Association (January 14, 2013), the California Supreme Court revisited the Pendergrass rule, concluding that it was time to overrule Pendergrass.
