In Boschma v. Home Loan Center, Inc. (— Cal.Rptr.3d —-, Cal.App. 4 Dist., August 10, 2011), a court of appeal considered whether a trial court erred in dismissing the fraud and unfair competition claims of homeowners who took out option adjustable rate mortgage loans. The court of appeal held that the trial court erred in dismissing the homeowners’ lawsuit because they adequately alleged fraud and unfair competition claims against their lender.
Clarence E. Boschma, Shirley C. Boschma (collectively, the “Boschmas”), and Sharon Robison (“Robison”) brought a lawsuit against the Home Loan Center, Inc. (“Lender”), alleging fraudulent omissions and violations of Business and Professions Code in connection with their option adjustable rate mortgage (“Option ARM”) loans. The Boschmas and Robison entered into Option ARM loans with a discounted initial interest rate, also known as a “teaser” rate, pursuant to which their monthly payments were insufficient to pay the interest accruing on the loan principals. Under this type of loan, a borrower who pays only the schedule payments during the first years of the mortgage will owe more than he or she did at the beginning of the loan. Another feature of an Option ARM is that “[a]fter an initial period of several years in which negative amortization can occur, a borrower’s payment schedule then recasts to require a minimum monthly payment that amortizes the loan.”
The Boschmas and Robison (collectively, “Borrowers”) alleged Lender’s loan documents did not “adequately and accurately disclose the essential terms of the loans, namely that [they] would suffer negative amortization if they made monthly payments according to the only payment schedule provided to them prior to the closing of the loan.” The Borrowers executed nearly identical notes that both contained the following disclaimer, the content of which was capitalized and in bold type: “This note contains provisions that will change the interest rate and the monthly payment. There may be a limit on the amount that the monthly payment can increase or decrease. The principal amount to repay could be greater than the amount originally borrowed, but not more than the limit stated in this note.”
Some relevant portions of the notes provide the following: (1) “I will pay interest at a yearly rate of 1.250%. The interest rate I pay may change;” (2) “The interest rate I will pay may change on the first day of April 1, 2006, and on that day every month thereafter;” (3) “I will pay principal and interest by making payments every month;” (4) “Each of my initial monthly payments will be in the amount of $833.13. This amount may change;” (5) “My monthly payment may change . . . on the 1st day of April, 2007;” and (6) “My monthly payment could be less than the amount of the interest portion of the monthly payment . . . .” The Option ARM program disclosure suggests that Borrowers could have a discounted rate, or they could have a premium rate. It also explains that the loan “allows for negative amortization” and that “the Interest Rate has the potential to increase each month but the payment changes are generally limited to once every twelve months, the monthly payment may be insufficient to pay the interest which is accruing . . . .”
The “Truth-in-Lending Disclosure Statement” (“TILDS”) for the Boschmas states that the annual percentage rate is 7.189%, the finance charge is $403,945.90, the amount financed is $246,805.35, and total payments will be $650,751.25. Robison’s TILDS contains the same categories of information with different amounts to reflect the terms of her loan. Both TILDS contain payment schedules that show increasing monthly payments after the first year. However, neither TILDS indicates how the initial year or subsequent payments are calculated. It is implicit in the Borrower’s payment schedules “that negative amortization will occur if [they] remit only the monthly payment amounts set forth in the payment schedule.”
Borrowers claim that they would not have entered into the loans if Lender had disclosed the payment amounts needed to avoid negative amortization. The trial court granted judgment in favor of Lender on the ground that the documentation for the loans contained adequate descriptions of the nature of the Option ARMs.
The Court of Appeal reversed the judgment of the trial court. The appellate court concluded that the Borrowers adequately alleged causes of action for fraud and violation of section 17200 of the Business and Professions Code.
Borrowers did not state a federal Truth in Lending Act (“TILA”) claim. However, TILA mandates certain disclosures by mortgage lenders including a requirement to disclose if an initial interest rate will be a discounted or a premium rate and whether there is a possibility of negative amortization. The court noted that a string of ARM cases, which involve similar Option ARM forms/disclosures as the ones used by Lender, “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.”
Here, Borrowers asserted state law claims instead of TILA claims so the question before the Court was whether Borrowers alleged state law causes of action. The Court held that they did. Borrowers adequately alleged causes of action for fraud. The Court found the actual interest rates and monthly payments that would be sufficient to amortize the loan (or at least pay the accruing interest) were hidden in the complexity of Borrowers’ Option ARM contract terms. The root of the alleged deficiencies in Lender’s disclosures is that it used “a significantly discounted ‘teaser’ rate rather than an initial rate set near the rate that would result from the application of the variable rate formula in the note (an index plus 3.5/3.25 percent).” This created an “artificially low” initial payment schedule, “which 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.”
The Court found that the language of Lender’s disclosure “is accurate absent a significantly discounted rate.” An Option ARM that lacks “a teaser rate would result in a higher initial interest rate, higher initial minimum payments pursuant to the payment schedule, and a much narrower gap (even if interest rates increased) between the borrower’s payment ‘options.’” However, the attractiveness of Option ARMs would be greatly diminished without a teaser rate because the payment and interest rate would initially be higher for the borrowers.
The Court found that Lenders had a legal duty under TILA to describe the terms of the loan in a clear and conspicuous manner and a duty under common law to avoid making misleading representations. If Borrowers’ factual allegations are true, Lender intentionally omitted information that would have given Borrowers a clear explanation of how the loan worked. Borrowers alleged Lender’s actions resulted in damage because they lost equity in their homes. After taking all of these factors into consideration, the Court concluded that Borrowers stated a cause of action for fraud.
The Court also found that Borrowers alleged a cause of action for violation of section 17200 of the Business and Professions Code, also known as the unfair competition law (“UCL”). Section 17200 does not prohibit specific activities, but instead “broadly prohibits ‘any unlawful, unfair or fraudulent business act or practice and unfair, deceptive, untrue or misleading advertising.’” The UCL’s major purpose is “the preservation of fair business competition.” The Court found that based on its analysis of Borrowers’ claims of fraud, they also stated causes of action under section 17200 for unlawful and fraudulent business practices. The Court, however, noted that it may be difficult for Borrowers “to prove they could not have avoided any of the harm of negative amortization” because “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.” The Borrowers, however, may be able to “show they were unable to avoid some substantial negative amortization.”
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Bruce A. Scheidt | 916.321.4500