One of the focuses of my bankruptcy practice is litigating Adversary Proceedings. I came across a case out of the Northern District of California. The first sentence under the heading of “Summary of Facts” read: “[t]his adversary proceeding is a poster child for some of the practices that have left to the current crisis in our housing market.” Clearly, this was something I had to read – and share with you.
The debtors in this case bought their home 20 years ago for $220,000. Like many homeowners, they refinanced several times. In April 2006, the debtors obtained a refinancing for the second mortgage in the amount of $200,000, in the form of an equity line of credit. In April 2007, they filed chapter 7 and at that time, the debt secured by the house was $683,000. Unfortunately, by that time, the house had been lost to foreclosure.
The debtor’s incomes were fairly modest. The husband was an auto parts manager and earned about $39,000 depending on over time, and the wife was self-employed, and like many self-employed, her income fluctuated. In 2006, the combined gross income between the two was $65,000. But on the loan application for the April 2006 re-fi, the debtors’ combined monthly income was listed as $12,143 ($145,716 per year). The mortgage broker claimed he obtained the wife’s income information over the phone and inputted it into the application, which was then sent to the debtors. The wife did notice an error on the application and called the broker to correct it. However, she denied telling the broker she or her husband earned those amounts.
By October 2006, debtors needed more cash, and the bank increased their credit line to $250,000. This time, the wife dealt directly the bank, and according to the October Loan Application (which was prepared the same way as the April application), the total combined income was $15,900 ($190,800 per year). The wife denied giving the bank this information.
Both the April loan and the October loan were “stated income” loans that did not require verification of income. A bank witness testified that the loans were generated or the purposes of selling them, and that certain guidelines had to be followed to make them marketable. He claimed that the bank followed those guidelines.
According to these guidelines, the only verification required was that of employment, not of income. However, the guidelines also stated hat a third party would evaluate the reasonableness of the stated income based on a number of factors. Yet there was no evidence that the third party vendor evaluated whether the debtors’ incomes were reasonable in light of their jobs.
The proceeds from the foreclosure sale were only enough to satisfy the first mortgage. So the bank sued the debtors, claiming that the debt was nondischargeable because it was incurred through a fraud in writing (violating Section 523(a)(2)(B)).
The debtors conceded that the applications that were submitted contained false information concerning their incomes. They also conceded that the representation was material, because had it been accurate, the bank would not have read the loans. The court found that the bank proved that the debtor’s also had the intent to deceive the bank. While they did not provide the false figures, they signed the application even though they also claim they did not read it. Yet if they did not read it, why did the wife call the broker to correct an error on the April application. If anything, the debtor demonstrated a reckless disregard for the truth.
Despite all of these important factors that might point to the fault of the debtors, the bank lost the case because it could not demonstrate that it reasonably relied on the information provided by the debtors. Reliance, an essential element of proving nondischargeability, is measured by an objective standard.
Here, the court questioned whether the “guidelines” were objectively reasonable. Even if they were, there was clearly a “red flag” – the incomes of the debtors, in light of their job titles, called for more investigation. Another “red flag”: the fluctuation of income between the April application and the October application. Not only were the figures higher, but the amounts for each spouse was switched! The husband’s income was noted as $98,112 in April, and $67,200 in October; the wife’s income was noted as $67,200 in April and $123,600 in October. The bank had the information on hand. Either the bank did not rely on the debtors representations, or its reliance was not reasonable.
[T]he Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank’s loss, and the Bank’s claim should be discharged.
In this case, the debtors with an “income stated” loan and who demonstrated a reckless disregard for the truth managed to obtain a discharge of the debt. But while these debtors were lucky, more litigation on these issues can be expected in the future. Debtors should expect the possibility of banks and investors fighting dischargeability of loan products such as this one if there is evidence of misrepresentation on the loan applications. Will those debtors be as successful in getting these debts discharged? It will all depend on the unique circumstances in their case, and how the case law develops in the months and years ahead.
National City Bank v. Hill, 07-4106, US Bankruptcy Court, Northern District of California, May 23, 2008
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