Courts Side With Borrowers Over Lenders

by Fredric J. Gooch - General Counsel/VP of Compliance

An unprecedented increase in mortgage industry litigation is reinforcing the fact that lenders must ensure that they are in exact compliance with all applicable laws, regulations and lending guidelines.  A deviation from exact compliance can have dramatic effect on a lender's ability to enforce its rights according to the law.  A recent case in the United States Bankruptcy Court for the Northern District of California illustrates the point that in this current legal climate, lenders cannot afford to stray from strict adherence to all guidelines.

On May 28, 2008 the United States Bankruptcy Court for the Northern District of California held that even though the borrowers intentionally misrepresented their income on their loan application for a HELOC, the debt was dischargeable in Chapter 7 bankruptcy because the lender could not have reasonably relied on the misrepresentations.  In National City Bank vs. Hill (In Re Hill), No. 07-41137 (Bankr. N.D. Calif. May 28, 2008), the borrowers obtained a HELOC from National City Bank for $200,000 in April of 2006.  In connection with this loan the borrowers stated their income to be $145,716.  In October of 2006 the borrowers applied to increase their HELOC limit to $250,000 and stated their income to be $190,800.  The debtors' income never exceeded $65,000.  The home was foreclosed in April 2007 and the property was purchased by the first lien creditor.  The debtors subsequently filed for relief under Chapter 7 of the bankruptcy code.  National City sued to exclude the HELOC debt from the debtors' discharge claiming that the debtors lied about their income and that they relied upon the misrepresentations.

The court entered judgment for the debtors holding that the claim was dischargeable.  In what the court described as a “poster child for some of the practices that have led to the current crisis in the housing market,” it reasoned that although the debtors had made a representation which they knew to be false, and the representation was material and that they made the misrepresentation with intent to deceive the bank, the bank could not prove the reasonableness of their reliance on the misrepresentation.  The “reasonableness of reliance” is measured by an objective standard.  A lender’s reliance is reasonable if it follows its normal business practices.  However, the court stated that following business practices may not be enough if the practice deviates from industry standards or if the creditor ignores a “red flag.” 

The court questioned whether the industry standards as reflected in the loan program guidelines were objectively reasonable, but it found that even if they were considered reasonable, the bank deviated from the guidelines.  The guidelines required an evaluation of the reasonableness of the salary provided by the borrower based on job type and geographical area.  The borrowers were self-employed and an auto parts manager.  The court found that the lender did not provide any evidence that the evaluation was performed.

The guidelines required that self-employment be verified by a letter from a CPA verifying the existence and ownership of the business.  A letter was provided on CPA letterhead, but the letter was not signed by a person identifying himself as a CPA.  Most importantly the court held that the lender ignored the “red flag” of the discrepancy of the income reported between the April and October applications.  The court concluded that the bank did not rely on the debtors' misrepresentations concerning their income or that its reliance was not reasonable based on the objective standard.  The court stated that the loan was clearly based on the value of the collateral and that the appraisal ordered by the bank was inflated.  The court held that the debtors could not be blamed for the bank's loss and that the bank's claim should be discharged in the bankruptcy.

This case is an excellent example of the legal climate in which lenders must now operate.  Even though the borrowers committed fraud on their loan application the court still ruled in their favor because the lender failed to strictly adhere to the technicalities of the loan program guidelines.  It is clear that courts are going to continue to scrutinize lenders and hold them to extremely high standards.  To operate in this climate lenders must make compliance with loan program guidelines, laws and all applicable rules and regulations one of their highest priorities.  Now is the time to make sure that your company is operating completely within all applicable guidelines and make sure that you are implementing systems and choosing partners that share this commitment to compliance.