Saturday, July 19, 2008

Tchaikovsky's Overture: How an Unremarkable Case Took on a Life of Its Own

Peter Tchaikovsky's 1812 Overture ends with a cannonade. Some commentators have viewed a recent opinion from Bankruptcy Judge Leslie Tchaikovsky as a cannon shot aimed at the irresponsible practices of the home mortgage industry. However, what is most remarkable about National City Mortgage vs. Hill, No. 07-4106 (Bankr. N.D. Cal. 5/28/08) is how unremarkable the opinion is.

The Opinion

In the Hill case, the debtors purchased a home for $220,000 twenty years ago. By the time that they filed bankruptcy, they had incurred debt of $683,000 against the house, including a second lien debt to National City Mortgage for $250,000. However, the debtors' combined income never exceeded $65,000.

When the debtors first applied for a loan with National City Mortgage in April 2006, they stated that their combined income was $145,716 on an annual basis. Six months later, they asked the bank to increase their Home Equity Line of Credit from $200,000 to $250,000. This time they stated their income as $190,800 on an annual basis. The bank either did not notice or did not care that the debtors were asserting that their income had increased by $45,000 per year in the span of just six months.

After the debtors filed for chapter 7 bankruptcy in April 2007, the first lienholder foreclosed and the second lien to National City Mortgage was wiped out. National City Mortgage brought a dischargeability action based on submitting a false financial statement under 11 U.S.C. Sec. 523(a)(2)(B). The court had little trouble finding that the first five elements of the claim were established. The debtors had made knowingly made a false financial statement with intent to deceive the lender. However, the court found that the element of reasonable reliance was missing.

Section 523(a)(2)(B) is unusual in that the statutory language expressly requires that reliance on a false financial statement be reasonable. This contrasts with Section 523(a)(2)(A) which states that debts based upon fraud are non-dischargeable but does not spell out the standard for reliance. The Supreme Court has said that reliance must be "justifiable" under Sec. 523(a)(2)(A), which is a lesser standard than "reasonable." Field v. Mans, 516 U.S. 59 (1995)("While the Court of Appeals followed a rule requiring reasonable reliance on the statement, we hold the standard to be the less demanding one of justifiable reliance, and accordingly vacate and remand."). Thus, Congress required a higher level of reliance on written statements of financial condition.

Judge Tchaikovsky set out the standad for reasonable reliance as follows:

Whether the creditor reasonably relied on the materially false statement under Sec. 523(a)(2)(B) is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. (citation omitted). Absent other factors, a creditor's reliance on a statement of financial condition is reasonable if it followed it normal business practices. (citation omitted). Other factors that may affect whether the creditor's reliance on its own standard lending practices is reasonable include the standards of the creditor's industry in evaluating creditworthiness, and the existence of any "red flags" that would alert the reasonably prudent lender of the possibility that the information was inaccurate. (citation omitted).

Memorandum of Decision at 8.

This was what is known as a stated income loan. According to the creditor's own guidelines, it did not require verification of income. However, it did require that an independent contractor verify that the amount stated was reasonable and that for a self-employed person that the borrower provide a copy of the borrower's business license, a copy of a bank statement showing a balance equal to 1/10 of the stated annual income or a letter from a CPA verifying the existence and ownership of the business. The Court found that the lender did not follow its own guidelines. There was no evidence that a third party contractor had verified that it was reasonable for an auto parts manager in the San Francisco Bay area (the husband) to earn $98,112 on an annual basis. While the wife submitted a letter on a CPA's letterhead with regard to her sole proprietorship, the person who signed the letter was not the CPA. Thus, the bank failed to follow its own guidelines. The Court also found that the bank ignored obvious red flags. In April 2006, the debtors claimed that Mr.Hill's income was $98,112 and that Mrs.Hill's income was $47,604. However, in October 2006, the debtors claimed that Mr. Hill's income was $67,200 (a 33% drop) and that Mrs. Hill's income was $123,600 (a 300% increase). Reasonable minds would have wondered about such a dramatic fluctuation in income, but the bank apparently did not.

In denying the complaint, the court concluded:

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its relaiance was not reasonable based on an objective standard. In fact, the minimal verification required by an 'income stated' loan, as established by the Guidelines, suggestes that this type of loan is essentially an 'asset-based' loan. In other words, the 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.

Memorandum of Decision at 13.

The Response

While the opinion was rather unremarkable, one line in it drew a lot of attention. Near the beginning of the opinion, the Court stated, "This adversary proceeding is a poster child for some of hte practices that have led to the current crisis in the housing market." Memorandum of Decision at 2. According to one blogger who wrote the day after the opinion was released, "This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everwhere." BK Judge Rules Stated Income HELOC Debt Dischargeable, This comment was picked up on and repeated by dozens of bloggers. The Wall Street Journal ran a story with the headine "Are borrowers free to lie?" Amir Efrati, "Are Borowers Free to Lie?," Wall Street Journal, May 31, 2008, p. B2. An article on MSN Money on June 30, 2008 amplified the story, claiming that, "In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored." Liz Pulliam Webster, "Lenders create a bankruptcy monster,"

By this point, the focus on the legal definition of reasonable reliance had been lost. From the comments being circulated, it appeared that a crazy bankruptcy judge had declared war on the stated-income lenders, was countenancing lying by debtors and was letting borrowers off the hook for their misdeeds. One email which I received from a colleague asked me if I had heard about a case “in which the good judge held that despite the mendacity of the debtors, Mr. and Mrs. Hill (In Re Hill), National City Bank could not enforce, post petition, a home equity type of loan against the debtors post discharge.” He asked “Is this a case that you are aware of?” However, the debtors were not let off the hook. They lost their home of 20 years. What they did get was a discharge, something that debtors are entitled to if their creditors do not object or do not prove an exception to discharge.

We have been through this before. During the 1990s and early years of the 2000s, credit card lenders made a concerted effort to object to dischargeability in cases where debtors irresponsibly ran up their credit card debt. Many of these decisions focused on reliance or the lack thereof. E.g., In re Mercer, 246 F.3d 391 (5th Cir. 2001)(no reliance where creditor sent debtor pre-approved credit card);In re Eashai, 87 F.3d 1082 (9th Cir. 1996)(reliance justifiable where no red flags appeared).

In one noteworthy case, the court stated:

There is no reliance in this case. There is not even a scintilla of reliance in this case. . . .

The Plaintiff's extension of credit to the Defendant in this case was a result of their own negligent lending practices and the industry's negligent use of a faulty FICO score system which has been engineered to create the greatest amount of credit for the greatest number of working people in this country with artificially low monthly repayment requirements so that credit card companies can make the greatest amount of interest and profits possible. Losses such as this are simply a cost of doing business in such a greedy manner.

In re Akins, 235 B.R. 866, 874 (Bankr. W.D. Tex. 1999).

As long as lenders continue to make high risk loans, it is inevitable that some borrowers will default and file bankruptcy. If the loss results from the lender's own negligence, the debt will be dischargeable. This is nothing remarkable.

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