A California state court addressed for the first time whether a borrower can state claims under California law based on allegedly fraudulent Option ARM loan disclosures. While noting possible proof problems with plaintiffs’ case, the Fourth District Court of Appeal held that plaintiffs sufficiently alleged that loan documents inadequately disclosed negative amortization of Option ARM loans featuring “teaser” rates.

In Boschma v. Home Loan Center, Inc., No. G043716, __ Cal. App. 4th __ (Aug. 10, 2011), the Fourth District Court of Appeal held, after reviewing the complaint and loan documents, that a lender could be found to have concealed or suppressed material facts regarding an option adjustable rate mortgage loan (“Option ARM”) with a discounted initial interest rate (“teaser” rate) where the loan documents did not clearly state that making the minimum payments according to the payment schedule “definitely would result in negative amortization.” The court noted that no California state courts had addressed whether a borrower can state a claim for violations of state law based on allegedly fraudulent, unlawful and unfair disclosures for an Option ARM with a teaser rate. The court emphasized that, at this juncture, it was obligated to accept plaintiffs’ allegations as true and to construe those allegations broadly. But, it also identified potential problems with plaintiffs’ case going forward, including that plaintiffs may be unable to prove compensable injury or intent, or to identify a putative class. In light of this ruling, lenders that offer ARM loans involving negative amortization may want to review their loan disclosures.

Key to the court’s analysis is that when an Option ARM loan includes a teaser rate, early on the borrower’s minimum monthly payments may be less than the monthly interest accruing on the loan principal. If the scheduled payments are made, “negative amortization” occurs—rather than amortizing the loan with each monthly payment, in the early years of the loan, the borrower’s principal balance actually increases. After an initial period in which negative amortization can occur, a borrower’s payment schedule recasts to require minimum monthly payments that amortize the loan.

Plaintiffs’ complaint alleged (i) that defendant failed to disclose that its Option ARMs were designed to cause negative amortization, (ii) that the payment schedule was based on the introductory “teaser” rate, and (iii) that negative amortization was “certain” to occur if plaintiffs followed the contractual payment schedule. Plaintiffs further alleged that they would not have entered into the loans if they had known the scheduled payment amounts would cause negative amortization.

Court Construes Allegations Broadly and Finds Complaint Sufficient at This Stage of the Litigation

The court’s analysis addressed the elements of a state law claim for fraudulent omission as follows:

  • Concealed or suppressed material facts. Plaintiffs claimed that defendant’s disclosures suggested only that negative amortization “could occur” and that interest payments “may change” from the original schedule due to future interest rate variability. Even though a would-be borrower might discover through careful analysis of the note and payment schedule that negative amortization would—and not merely could—occur, the court found that defendant “did not clearly state in the loan documents that plaintiffs were receiving a discounted initial interest rate and that making the minimum payments according to the… payment schedule definitely would result in negative amortization.” It noted that plaintiffs’ actual interest rates and monthly payments sufficient to amortize the loan (or at least pay the accruing interest) were hidden in the complexity of the Option ARM contract terms. Ultimately, it concluded that plaintiffs “adequately pleaded that material facts were concealed by inaccurate representations and half-truths.”
  • Defendant’s duty to disclose. The court recognized that the defendant “certainly had a legal duty under the Truth in Lending Act … (TILA), to clearly and conspicuously describe the terms of the loan to plaintiffs.” In addition, it found that defendant had a common law duty independent of TILA to avoid making partial, misleading representations that effectively concealed material facts.
  • Intent to defraud. Although noting potential proof problems, the Court accepted as true plaintiffs’ allegations that “defendant intentionally omitted a clear disclosure of the nature of plaintiffs’ loans because giving a clear explanation of how the loan worked would have punctured the illusion of a low payment, low interest rate loan.”
  • Reliance. Accepting as true plaintiffs’ allegations that they would not have entered into the loans if the concealed information had been disclosed, the court concluded it would be “improper to adjudicate the factual question of actual reliance at the demurrer stage.” It rejected defendant’s contention that the disclosures given to plaintiffs precluded reasonable reliance, but noted that the mere fact that borrowers took out Option ARMs does not necessarily prove they were misled by the disclosures.
  • Resulting damages. The court concluded that plaintiffs’ allegation of lost home equity was sufficient to survive defendant’s demurrer. It construed this allegation broadly to include the assertion that the plaintiffs lost equity in their homes because the terms of the Option ARM loan put them in worse economic positions than they would have occupied had they utilized a different credit product. But, the court found lost home equity to be a “problematic” theory of damages.

The court’s conclusions on the fraud claim were also construed to support its holding that plaintiffs sufficiently alleged a claim under each of the three alternative prongs of California’s unfair competition law, Business & Professions Code Sections 17200, et seq. In doing so, the court rejected defendant’s argument that its strict compliance with TILA provided a “safe harbor” defense. It reasoned that, although the disclosures regarding negative amortization might be literally true, they might nonetheless fail TILA’s “clear and conspicuous” requirement. The court cited a string of federal cases holding that certain negative amortization disclosures did not pass muster under TILA’s clear and conspicuous standard.

Court Highlights Problems Plaintiffs Will Encounter at Future Stages of the Litigation

Although the court found the complaint sufficient to defeat defendant’s demurrer, it highlighted potential problems with plaintiffs’ case going forward. Most notably, it found plaintiffs’ damages theory problematic:

Every month in which plaintiffs suffered negative amortization was a month in which they enjoyed payments lower than the amount needed to amortize the loan (or even to pay off the accruing interest). In exchange for gradually declining equity, plaintiffs retained liquid cash they otherwise would have paid to defendant (or another lender). Viewed in this manner, plaintiffs’ only “injury” is the psychological revelation (whenever it occurred) that they were not receiving a free lunch from defendant: plaintiffs could have low payments or pay off their loan, but not both at the same time.

The concurring opinion emphasized that, to prove their alleged damages, plaintiffs will need to show more than the fact that their loan balances increased as a result of negative amortization.

Another potential problem concerned proving intent to defraud. The court accepted as true plaintiffs’ allegation that the defendant intentionally omitted a clear disclosure to avoid “punctur[ing] the illusion of a low payment, low interest loan.” However, it noted an “alternate explanation” may be defendant utilized one set of forms for all Option ARMs. “Perhaps these forms were selected in an effort to comply with TILA requirements regardless of the particular terms of an individual loan… rather than as a nefarious scheme to deceive consumers.” On demurrer, it declined to “weigh the likelihood of these competing narratives.”

Finally, the court indicated potential problems regarding reliance, noting that not all Option ARM borrowers necessarily were misled by the disclosures. “Borrowers who understood the terms of the loan may still have agreed to the loan because it enabled them to buy now and pay later.” The court’s observation also foreshadows potential problems with identifying and proving a putative class.

Boschma is a reminder that TILA does not preempt state law claims and lenders should be aware of consumer protection laws that may impose stricter disclosure obligations than those imposed by TILA.

Click here to read Boschma v. Home Loan Center, Inc., No. G043716 (Aug. 10, 2011)