The defining feature of an option adjustable rate mortgage loan (Option ARM) with a discounted initial interest rate (i.e., a "teaser" rate) is, for a limited number of years, the borrower may (by paying the minimum amount required to avoid default on the loan) make a monthly payment that is insufficient to pay off the interest accruing on the loan principal. Rather than amortizing the loan with each minimum monthly payment (as occurs with a standard mortgage loan), "negative amortization" occurs—a borrower who elects to make only the scheduled payment during the initial years of the Option ARM owes more to the lender than he or she did on the date the loan was made. After 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.
In this case, plaintiffs
In conducting our de novo review, we "must `give[] the complaint a reasonable interpretation, and treat[] the demurrer as admitting all material
The Boschmas refinanced their existing home loan with defendant on or about February 1, 2006, utilizing an Option ARM. Robison agreed to an Option ARM with defendant on or about November 22, 2005; the operative complaint does not specify whether her loan was a purchase money loan or a refinancing of an existing loan.
Plaintiffs attached copies of certain loan documents to the operative complaint. We will set forth the key provisions of these documents before detailing plaintiffs' allegations. (Barnett v. Fireman's Fund Ins. Co. (2001) 90 Cal.App.4th 500, 505 [108 Cal.Rptr.2d 657] ["we rely on and accept as true the contents of the exhibits and treat as surplusage the pleader's allegations as to the legal effect of the exhibits"].)
Plaintiffs executed nearly identical documents entitled "ADJUSTABLE RATE NOTE" (Note). The Note features a bold, capitalized disclaimer below its title and loan identification numbers: "
"1.
"2.
"3.
"
The referenced prepayment addendum states in relevant part: "Except as provided below, I may make a Full Prepayment or a Partial Prepayment at any time without paying any Prepayment charge. If within the first THREE (3) years(s) I make a Full Prepayment or Partial Prepayment(s) of more than twenty percent (20%) of the original principal amount in any twelve (12) month period, I will pay a Prepayment charge in an amount equal to the payment of six (6) months' advance interest on the amount prepaid in excess of twenty percent (20%) of the original principal amount. [¶] If I make a Partial Prepayment equal to one or more of my monthly payments, the due date of my next scheduled monthly payment may be advanced no more than one month. If I make a Partial Prepayment in any other amount, I must still make all subsequent monthly payments as scheduled."
Plaintiffs also received a three-page document entitled "ADJUSTABLE RATE MORTGAGE LOAN PROGRAM DISCLOSURE 12-MONTH AVERAGE OF MONTHLY 1-YR CONSTANT MATURITY INDEX PAYMENT-CAPPED NON-CONVERTIBLE ARM." "This disclosure describes the features of" the loan provided to plaintiffs. The middle of the first paragraph states in all capital letters: "THIS LOAN ALLOWS FOR NEGATIVE AMORTIZATION." The document uses bullet point explanations of the mechanics of the loan (on topics such as how interest rates are determined, how the interest rate can change, and how the payment can change), as well as examples showing the effect of interest rate fluctuations on payments made by a borrower. Our review of this material suggests it is consistent with the terms described in the Note.
On the first page of the disclosure, there is a category entitled "HOW YOUR INTEREST RATE AND PAYMENT ARE DETERMINED." This category includes the following five bullet points: "• Your interest Rate will be based on an Index Rate plus a Margin. Please ask us for our current Interest Rate and Margin. [¶] • Your initial Interest Rate will not be equal to an Index Rate plus a Margin. If the initial Interest Rate is below the then-current Index plus Margin (the `fully-indexed rate'), then the initial Interest Rate will be a `Discounted' Interest Rate. If the initial Interest Rate is above the then-current fully-indexed Interest Rate, then the initial Interest Rate will be a `Premium' Interest Rate. Please ask us about the current Discount or Premium. [¶] • The Index Rate is based on the twelve-month average of monthly yields on actively traded United States Securities . . . .
On page 2 of the disclosure, there is a category entitled "DEFERRED INTEREST." "Deferred interest (also known as Negative Amortization) may occur in two ways: [¶] • Because 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; and/or [¶] • When normal payment changes occur every twelve months, the payment is limited to an increase of 7.500% from the previous payment amount, which may be less than the interest that is accruing. [¶] If the interest due on your loan for a month is more than the required monthly payment, the entire payment will be applied to interest and any unpaid interest will be added to the loan balance. The interest for the next month is then calculated on the new increased loan balance. [¶] `Accelerated Amortization' may occur if the Interest Rate decreases . . . ."
"In addition to the Minimum Monthly Payment, you have two other options in making your payment. You may make a fully amortizing payment that is a payment that pays all the interest owed for the month plus principal or you may also choose to make a monthly `interest-only' payment. The fully amortizing payment and the interest-only payment is available only if the payment amount is greater than the Minimum Monthly Payment option. An interest-only payment amount will cover the full interest costs for that month; therefore, no additional (deferred) interest will be added to your loan balance. Your principal balance will not be increased or reduced. An interest-only payment is allowed until a fully amortizing payment is required as described above."
The Boschmas' Truth-in-lending disclosure statement (TILDS) includes the following information in a series of boxes near the top of the form: "ANNUAL PERCENTAGE RATE [¶] The cost of your credit at a yearly rate [¶] 7.189 %"; "FINANCE CHARGE [¶] The dollar amount the credit will
The TILDS also displays a payment schedule. The Boschmas' payment schedule is as follows:
Number of Payments Amount of Payment When Payments Are Due
1 833.13 04/01/06
11 833.13 05/01/06
12 895.61 04/01/07
12 962.78 04/01/08
5 1,034.99 04/01/09
318 1,922.49 09/01/09
1 1,926.24 03/01/36
Robison's payment schedule is as follows:
Number of Payments Amount of Payment When Payments Are Due
1 499.88 01/01/06
11 499.88 02/01/06
12 537.37 01/01/07
12 537.37 01/01/08
12 621.00 01/01/09
5 667.58 01/01/10
306 1,111.06 06/01/10
1 1,111.96 12/01/35
The TILDS includes two additional noteworthy features. First, a line is marked indicating "
The TILDS does not explain how the initial payments for the first 12 months of the payment schedule ($833.13 for the Boschmas, $499.88 for
To explain the first 12 payments, one must look to section 3(B) of the Note, which sets the "initial monthly payments" for the borrower ($833.13 for the Boschmas, $499.88 for Robison). Although none of the documents explain how this number is derived, it can be "reverse engineered" as follows: (1) identify the principal amount from section 1 of the Note ($250,000 for the Boschmas, $150,000 for Robison); (2) select the interest rate listed in section 2(A) of the Note (1.25 percent), not the APR (annual percentage rate) listed in the TILDS; and (3) using a mortgage calculator, calculate the monthly payment for a 30-year fixed rate, fully amortizing mortgage based on the interest rate listed in section 2(A) of the Note and the principal listed in section 1 of the Note. For the Boschmas: $250,000 borrowed at 1.25 percent equals 360 payments of $833.13. For Robison: $150,000 borrowed at 1.25 percent equals 360 payments of $499.88.
Of course, this is not actually a fixed rate loan. As explained in section 2(B) of the Note, the Boschmas' interest rate "may change on the first day of April 1, 2006, and on that day every month thereafter."
The TILDS payment schedule reflects this reality by its steadily increasing payment amounts. Pursuant to section 3(C) of the Note, the first payment change date is April 1, 2007, for the Boschmas and January 1, 2007, for Robison. According to their respective TILDS, the Boschmas' payment increases to $895.61 as of April 1, 2007, and Robison's payment increases to $537.37 as of January 1, 2007. These increases are derived from section 3(D) of the Note, which limits a "new monthly payment . . . to an amount that will not be more than 7.5% greater or less than the amount of my last monthly payment due before the Payment Change Date." Thus, for the Boschmas: $833.13 + ($833.13 × .075) = $895.61. And for Robison: $499.88 + ($499.88 ×.075) = $537.37. Likewise, additional payment increases each year are derived by increasing the prior payment by 7.5 percent (Boschmas: $895.61 to $962.78 to $1,034.99; Robison: $537.37 to $577.67 to $621 to $667.58). That is, until the penultimate, more drastic increases to $1,922.49 (for the Boschmas) and
The gravamen of plaintiffs' operative complaint is that defendant failed to disclose prior to plaintiffs entering into their Option ARM's: (1) "the loans were designed to cause negative amortization to occur"; (2) "the monthly payment amounts listed in the loan documents for the first two to five years of the loans were based entirely upon a low `teaser' interest rate (though not disclosed as such by Defendants) which existed for only a single month and which was substantially lower than the actual interest rate that would be charged, such that these payment amounts would never be sufficient to pay the interest due each month"; and (3) "when [plaintiffs] followed the contractual payment schedule in the loan documents, negative amortization was certain to occur, resulting in a significant loss of equity in borrowers' homes, and making it much more difficult for borrowers to refinance the loans [because of the prepayment penalty included in the loan for paying off the loan within the first three years of the loan]; thus, as each month passed, the homeowners would actually owe more money than they did at the outset of the loan, with less time to repay it."
Plaintiffs allege that instead of clearly describing the consequences of making the scheduled payments set forth in the TILDS, the actual disclosures in the loan documents suggest only that negative amortization could occur and that payments may change from the original schedule based on future variability in interest rates. "Borrowers were not provided, before entering into the loans, with any other payment schedule or with any informed option to make payments different than those listed in the [TILDS] payment schedule." "[H]ad Defendant disclosed the payment amounts sufficient to avoid negative amortization from occurring [plaintiffs] would not have entered into the loans."
Plaintiffs allege this information was material to their decision to accept Option ARM's and they would not have entered into their Option ARM's had defendant made accurate disclosures. Plaintiffs allege defendant actively concealed and suppressed material facts from plaintiffs. "Defendants purposefully and intentionally devised this Option ARM loan scheme of flatly omitting material information and, in some cases, making partial representations while omitting material facts, in order to deceive consumers into
With regard to their section 17200 claim, plaintiffs allege defendant's practices (as described above) were unlawful, unfair, and fraudulent. Plaintiffs identify their "injury and lost money and property" as "the amount of negative amortization resulting from Defendant's scheme."
The court sustained defendant's demurrer to the second amended complaint without leave to amend and entered judgment of dismissal. At the hearing, the court explained that "the loan documents . . . show detailed, highlighted and repeated warnings regarding the interest rate changes, adequacy of payments to cover both principal and interest, and the prospect of the negative amortization." According to the court, the second amended complaint "seems to allege that negative amortization was not certain, and that it could be avoided by making payments larger than those that were mandated by the payment schedule." The court denied further leave to amend because plaintiffs did not think they could improve upon their pleading based on the court's stated rationale for its decision.
"`On appeal from a dismissal after an order sustaining a demurrer, we review the order de novo, exercising our independent judgment about whether the complaint states a cause of action as a matter of law.'" (Batt v. City and County of San Francisco (2007) 155 Cal.App.4th 65, 71 [65 Cal.Rptr.3d 716].)
It is important to demarcate the boundaries of this dispute. The following are not at issue in this case: (1) should it be legal to offer Option ARM's to typical mortgage borrowers and (2) should it be legal to utilize teaser (discounted) interest rates (here 1.25 percent for the first month of a 30-year loan), which bear no relation to the actual cost of credit? Our only concern in this case is whether plaintiffs stated a cause of action under state law based on defendant's allegedly misleading, incomplete, and/or inaccurate disclosures in the Option ARM documents provided to plaintiffs.
It does not appear California state courts have addressed this precise issue. But there are a plethora of federal district court opinions addressing whether
Although plaintiffs do not allege a TILA claim or specifically base their section 17200 claim on a violation of TILA,
Regulation Z obligates creditors providing "closed-end credit" (such as a mortgage) to "make the disclosures required by this subpart clearly and
Variable rate mortgage borrowers must be provided with "[a] loan program disclosure" that includes "[a]ny rules relating to changes in the index, interest rate, payment amount, and outstanding loan balance including, for example, an explanation of interest rate or payment limitations, negative amortization, and interest rate carryover." (12 C.F.R. § 226.19(b)(2)(vii).) "If the initial interest rate will be a discount or a premium rate, creditors must alert the consumer to this fact." (12 C.F.R. § 226, Supp. I, par. 19(b)(2)(v)(1) (2011).) "A creditor must disclose, where applicable, the possibility of negative amortization. For example, the disclosure might state, `If any of your payments is not sufficient to cover the interest due, the difference will be added to your loan amount.' . . . If a consumer is given the option to cap monthly payments that may result in negative amortization, the creditor must fully disclose the rules relating to the option, including the effects of exercising the option (such as negative amortization will occur and the principal loan balance will increase) . . . ." (12 C.F.R. § 226, Supp. I, par. 19(b)(2)(vii)2 (2011).)
Velazquez, supra, 605 F.Supp.2d at page 1065, clearly and concisely states the reasoning relied upon by these courts with regard to the issue of negative amortization: "All disclosures framed negative amortization as a possibility. The disclosures are perhaps literally accurate: they state that paying less than
We find the above cited federal district court cases to be persuasive. Cases reaching contrary results are inapposite or unconvincing. (See Taylor v. Homecomings Financial, LLC (N.D.Fla. 2010) 738 F.Supp.2d 1257, 1267 [explicitly noting its analysis of the disclosure issue was under Fla.'s state unfair competition law]; Wallace v. Midwest Financial & Mortgage Services, Inc. (E.D.Ky. 2010) 728 F.Supp.2d 906, 917-918 [granting summary judgment on TILA claim and observing plaintiff "cites to no case law, specific statutes, or regulations to support his claim that the numerous loan disclosures provided to him throughout the loan process were inadequate under TILA"]; Conder v. Home Savings of America (C.D.Cal. 2010) 680 F.Supp.2d 1168, 1172-1174 [granting motion to dismiss TILA claim—plaintiff did not allege loan failed to disclose certainty of negative amortization by paying according to payment schedule].)
The trial court cited a single case in support of its ruling, Chetal v. American Home Mortgage (N.D.Cal., Aug. 24, 2009, No. C 09-02727 CRB) 2009 WL 2612312, page *1 (Chetal). But the procedural posture of Chetal was a motion for preliminary injunction brought by the Option ARM borrower (thus, the court addressed the merits), not a motion to dismiss brought by the lender. (Ibid.; see also Appling v. Wachovia Mortgage, FSB (N.D.Cal., June 9, 2010, No. C 10-01900 JF (PVT)) 2010 WL 2354138, pp. *1, *6-*7 [denying borrower's preliminary injunction motion, while acknowledging cases holding borrower states a TILA claim based on similar allegations].)
As already stated, plaintiffs did not allege a TILA claim (or borrow a TILA violation as the basis for the § 17200 claim) in the current iteration of their complaint. Thus, the real issue is not whether TILA was violated but instead whether plaintiffs sufficiently alleged a state law cause of action.
Several federal district court cases that allowed TILA claims to proceed past the motion to dismiss stage simultaneously denied motions to dismiss state law fraud and unfair business practices claims based on the same underlying factual allegations. (E.g., Ralston I, supra, 2009 WL 688858 at pp. *7-*8; Velazquez, supra, 605 F.Supp.2d at pp. 1067-1068; Amparan v. Plaza Home Mortgage, Inc. (N.D.Cal. 2008) 678 F.Supp.2d 961, 975-977.)
More pertinently, three federal district court cases denied motions to dismiss state fraud and section 17200 claims even though the borrowers did not state valid TILA claims. (Jordan, supra, 745 F.Supp.2d at pp. 1095-1100 [allowing UCL (unfair competition law) claim to proceed on fraudulent and unfair prongs but not unlawful prong]; Ralston v. Mortgage Investors Group, Inc. (N.D.Cal., Aug. 12, 2010, No. C 08-536 JF (PVT)) 2010 WL 3211931, pp. *3-*6 (Ralston II); Brooks v. ComUnity Lending, Inc. (N.D.Cal., July 6, 2010, No. C 07-4501 JF (PVT)) 2010 WL 2680265, pp. *1-*3, *9-*13 (Brooks).)
Nevertheless, the trial court sustained defendant's demurrer to both causes of action because it found the loan documents disclosed the material facts of
Actual fraud consists, among other things, of "[t]he suppression of that which is true, by one having knowledge or belief of the fact" or "[a]ny other act fitted to deceive." (Civ. Code, § 1572, subds. 3, 5; see also Civ. Code, § 1710, subd. 3 [definition of "deceit" includes "[t]he suppression of a fact, by one who is bound to disclose it, or who gives information of other facts which are likely to mislead for want of communication of that fact"]; Vega v. Jones, Day, Reavis & Pogue (2004) 121 Cal.App.4th 282, 292 [17 Cal.Rptr.3d 26] (Vega) ["active concealment or suppression of facts . . . is the equivalent of a false representation"].)
First element: Did plaintiffs adequately plead concealed or suppressed material facts? We agree with Jordan, supra, 745 F.Supp.2d 1084, that, with regard to the alleged fraudulent omissions at issue, the enhanced pleading burden of a fraud claim is met by the attachment of the relevant Option ARM documents: "[P]laintiffs' evidence is the mortgage instrument, which provides the specific content of the allegedly false representations related to negative amortization, as well as the date and place of the alleged fraud. While the precise identities of the employees responsible . . . are not specified in the loan instrument, defendants possess the superior knowledge of who was responsible for crafting these loan documents." (Id. at p. 1096.)
The closer question is whether defendant can be deemed to have concealed or suppressed material facts even though at least some of these facts can be distilled from the loan documents through careful analysis of the Note and
We restate some of the relevant terms from the Option ARM documents. The Note states, in relevant part: (1) Section 2(A)—"I will pay interest at a yearly rate of 1.250%. The interest rate I pay may change"; (2) Section 2(B)—"The interest rate I will pay may change on the first day of April 1, 2006, and on that day every month thereafter"; (3) Section 3(A)—"I will pay principal and interest by making payments every month"; (4) Section 3(B)— "Each of my initial monthly payments will be in the amount of $833.13. This amount may change"; (5) Section 3(C)—"My monthly payment may change . . . on the 1st day of April, 2007"; and (6) Section 3(E)—"My monthly payment could be less than the amount of the interest portion of the monthly payment . . . ." The program disclosure suggests that plaintiffs might have a discounted rate, or they might have a premium rate. The program disclosure explains that the Option ARM "ALLOWS FOR NEGATIVE AMORTIZATION." The program disclosure states: "Because 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 root of the alleged deficiencies in defendant's disclosures is defendant's use of a significantly discounted teaser rate rather than an initial rate set
Second element: Did defendant have a duty to disclose the allegedly concealed material facts to plaintiffs? Defendant certainly had a legal duty under TILA to clearly and conspicuously describe the terms of the loan to plaintiffs. (Ralston II, supra, 2010 WL 3211931 at pp. *4-*5.) And, even ignoring TILA, defendant had a common law duty to avoid making partial, misleading representations that effectively concealed material facts. (See Randi W. v. Muroc Joint Unified School Dist. (1997) 14 Cal.4th 1066, 1082-1084 [60 Cal.Rptr.2d 263, 929 P.2d 582]; LiMandri v. Judkins (1997) 52 Cal.App.4th 326, 336 [60 Cal.Rptr.2d 539].)
Third element: Did defendant conceal or suppress the truth about negative amortization with the intent to defraud plaintiffs? Taking plaintiffs' factual allegations to be true, defendant intentionally omitted a clear disclosure of the nature of plaintiffs' loans because giving a clear explanation of how the loans worked would have punctured the illusion of a low payment, low interest rate loan. An alternate explanation might be that defendant (apparently like many other mortgage lenders, as evidenced by the repetition of the same disclosures in cases discussed herein) utilized a set of forms for all Option ARM's. Perhaps these forms were selected in an effort to comply with TILA requirements regardless of the particular terms of an individual loan (e.g., whether a discounted interest rate was used) rather than as a nefarious scheme to deceive consumers. But we will not weigh the likelihood of these competing narratives on demurrer.
Fifth element: Did plaintiffs suffer damages as a result of defendant's fraud? Plaintiffs' theory of damages (lost home equity) is 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 that 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 loans, but not both at the same time. But plaintiffs' allegation of lost equity in their homes is sufficient at this stage of the proceedings to overrule defendant's demurrer. We construe plaintiffs' allegations (including the allegation that the prepayment penalty precluded refinancing into a better loan) broadly to encompass an assertion that they were misled into agreeing to Option ARM's, which led to lost equity in their homes because the terms of the Option ARM's put them in a worse economic position than they would have been had they utilized a different credit product (i.e., by deciding not to refinance their previous loans or by taking out a more suitable loan).
With regard to their section 17200 claim, plaintiffs rely heavily on the concept of fraud. Although the second amended complaint alleges "unlawful" behavior, the only statutes specifically cited are Civil Code sections 1572 (actual fraud—omissions), 1573 (constructive fraud by omission), and 1710 (deceit). Based on our analysis of plaintiffs' common law fraud claim, we conclude plaintiffs have adequately pleaded a section 17200 claim under the unlawful and fraudulent prongs.
Plaintiffs' "unfair" allegations also focus on the same material omissions/misleading disclosures in the loan documents. Jordan, supra, 745 F.Supp.2d at page 1100, found the plaintiffs adequately pleaded that Option ARM loans with conditional disclosures with regard to negative amortization were "unfair" under the UCL: "Plaintiffs have sufficiently alleged that they did not discover the certainty of negative amortization until they were `locked in' with a harsh prepayment penalty under the terms of the agreement. They allege that the loan documents do not clearly specify the certainty of negative amortization. . . . Additionally, the payment schedule does not clearly indicate it is based upon the teaser rate rather than the APR listed on the top of the page. Thus, plaintiffs have sufficiently alleged that an ordinary consumer relying on the plain language of the loan agreement might not have been able to avoid the injury of negative amortization because they did not understand it was certain to occur."
We agree. As noted above in our discussion of damages, it may be difficult for plaintiffs to prove they could not have avoided any of the harm of negative amortization—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. But plaintiffs may show they were unable to
The judgment is reversed. The trial court is directed to overrule defendant's demurrer to the second amended complaint. Plaintiffs' request for judicial notice is granted. Plaintiffs shall recover costs incurred on appeal.
Rylaarsdam, Acting P. J., and O'Leary, J., concurred.
I concur; plaintiffs stated facts sufficient to constitute causes of action. But I want to emphasize that, to prove they were damaged, plaintiffs must show more than the fact that, as a result of the negative amortization, their loan balances increased. This does
