In Heritage Pac. Fin., LLC v. Montano (In re Montano)
In Heritage Pac. Fin., LLC v. Montano (In re Montano), __ B.R. __, 2013 WL 5890681 (9th Cir. BAP Nov. 1, 2013), the U.S. Bankruptcy Appellate Panel of the Ninth Circuit held that California’s anti-deficiency statutes barred the successor to a mortgage lender from obtaining a nondischargeability judgment for a purportedly fraudulently induced loan against a borrower who misrepresented his financial condition. Specifically, the successor could not enforce the loan against the borrower despite the borrower’s alleged misrepresentations in his loan application because: (1) the loan was for less than $150,000, (2) the loan was secured by residential real property, and (3) the borrower occupied the property as his home. Furthermore, the BAP affirmed an award for attorneys’ fees to the borrower because it found that the plaintiff’s position was not substantially justified pursuant to 11 U.S.C. § 523(d).
Facts
In November 2006, Jesus Edgar Montano ("Montano") purchased a California home using a first loan of $348,750 and a second loan of $89,990 from WMC Mortgage Corporation ("WMC"). The loan application stated that Montano earned over $8,000 per month, over half of which came from Montano’s purported business, Montano Moving Services. The loan application contained three letters from satisfied customers of Montano Moving Services and a letter from a tax preparer that she had performed accounting services for the business for the past three years. Montano, a native of El Salvador, who could not read or write English, later contended that the loan broker fabricated the documents. The application also contained an audit form prepared by an individual who stated that he spoke with the tax preparer, who represented that Montano filed Schedule C (a profit and loss schedule for a sole proprietorship) tax information for the prior three years. Otherwise, the income in the application was not verified. After making only five payments on the loans, Montano defaulted on the loans, and WMC non-judicially foreclosed under the first loan on October 22, 2007. During that time, Montano occupied the property. Heritage Pacific Financial, LLC ("Heritage") purchased the now-unsecured note for the second loan over a year later on January 20, 2009.
In April 2010, Heritage filed a complaint in the Alameda County Superior Court alleging that Montano misrepresented his income in the loan application. On October 13, 2010, Montano filed a chapter 7 bankruptcy petition. Heritage timely filed a complaint to determine that its $89,990 claim against Montano was excepted from discharge for fraud under 11 U.S.C. § 523(a)(2)(A) and (B). Montano moved to dismiss and cross-claimed against Heritage seeking to recover his attorneys’ fees and cost pursuant to section 523(d).
The bankruptcy court denied Montano’s motion to dismiss. However, the bankruptcy court noted the difficulty Heritage would face in establishing that WMC, now a defunct company, reasonably relied upon Montano’s purported misrepresentations in the loan application.
Montano then moved for summary judgment contending, among other things, that California’s anti-deficiency statutes (in particular section 726 of the California Code of Civil Procedure) barred Heritage’s claim. Montano also requested attorneys’ fees. Heritage responded, arguing among other things, that the anti-deficiency statutes do not apply to claims against a borrower for fraud and do not apply to "sold-out" junior lienholders.
The bankruptcy court disagreed with Heritage and found that the anti-deficiency statutes applied to this case. The bankruptcy court noted that the loan was used to purchase an owner-occupied property and the loan amount fell within the limit in section 726(g) of the California Code of Civil Procedure. Accordingly, the bankruptcy court granted Montano’s motion for summary judgment because section 726(g) barred Heritage’s claim. However, the bankruptcy court denied Montano’s request for attorneys’ fees.
Montano then moved for reconsideration for his attorneys’ fees. In considering the motion, the bankruptcy court focused on the reliance element of Heritage’s fraud claim and questioned whether Heritage had shown that WMC, the original lender, actually relied on Montano’s misrepresentation. Ultimately, the bankruptcy court found that Heritage failed to meet its burden and granted Montano’s motion for reconsideration of his attorneys’ fees under 11 U.S.C. § 523(d). Heritage timely appealed both judgments on the motions for the summary judgment and reconsideration.
Reasoning
The BAP affirmed the bankruptcy court’s rulings. The BAP held that the bankruptcy court correctly granted Montano’s motion for summary judgment because section 726(g) of the California Code of Civil Procedure barred Heritage’s claim.
The BAP analyzed section 726 of the California Code of Civil Procedure. Under this statute, often referred to as the one-action rule, a lender’s primary remedy to collect a loan secured by a mortgage or deed of trust is to foreclose. Section 726(f), however, provides an exception to the one-action rule; a creditor may bring an action to recover damages based on a borrower’s fraudulent conduct that induced the original lender to make a loan. Section 726(g), provides an exception to this exception, making it clear that the lender may not pursue such fraud claim if (1) the loan was secured by "owner-occupied residential real property," (2) the property was actually occupied by the borrower, and (3) the loan was for $150,000 or less.
The BAP found that the facts in this case satisfied the exception set forth in section 726(g). Heritage argued that the bankruptcy court should have aggregated the dollar amount of first and second loans in determining the dollar limit of section 726(g), thereby making Montano’s loans total $438,740. However, the BAP rejected Heritage’s argument because it contradicted the plain meaning of the statute. In reaching this conclusion, the BAP highlighted that the amount and method of calculating the cap in section 726(g) was never amended, even though the California Legislature has amended section 726 four different times.
Additionally, the BAP affirmed the bankruptcy court’s grant of Montano’s motion for reconsideration and award of attorneys’ fees under 11 U.S.C. § 523(d). The BAP explained that to support a request for attorneys’ fees under section 523(d), a debtor initially needs to prove that: (1) the creditor sought to except a debt from discharge under section 523(a); (2) the debt was a consumer debt; and (3) the debt ultimately was discharged. Once these elements are established, the burden of proof shifts to the creditor to prove that its action was substantially justified.
The BAP found that Montano satisfied the three factors. The bankruptcy court, however, did not initially require Heritage to satisfy its burden of proof. Thus, because the burden of proof shifted to Heritage who was not required to prove its burden, the BAP held that the reconsideration was proper.
The BAP affirmed the bankruptcy court’s ruling that Heritage failed to prove that WMC reasonably relied on Montano’s misrepresentation. Though the case had lasted a year since the bankruptcy court first raised the issue at the hearing on Montano’s motion to dismiss, Heritage provided no proof of reliance, which was a necessary element of Heritage’s claim. Because Heritage failed to prove that its fraudulent claim against Montano was substantially justified, the award for attorneys’ fees to Montano was proper.
Commentary:
The opinion explores overlooked exceptions to California’s one-action rule. The opinion is more influential, however, as a cautionary tale for debt purchasers rather than for its exploration of the arcana of the one-action rule. Underlying the BAP’s decision is the bankruptcy court’s astute foresight early in the case that it would be difficult for the creditor to find the right person in the prior lender’s organization, a lender which is now defunct, who could credibly testify that the lender reasonably relied upon the borrower’s representations in order to satisfy section 523(a)(2)(B). This evidentiary difficulty is buttressed by poor underwriting. Had the original lender actually required the borrower’s filed tax returns, payment advices, receipts, invoices, bank statements, and any other documented sources of income to verify the information in the loan application, the creditor may have had a better chance at showing that it was substantially justified in pursuing the action. The perils of this failure are not inconsequential. The creditor now owes the borrower all of its attorneys’ fees and costs in defending against the action, over $70,000, not including the costs of the appeal, nearly the same amount as the loan at issue, which may alter the cost-benefit analysis for pursuing such actions.
The foregoing analysis is from the California State Bar Business Law Section’s INSOLVENCY LAW COMMITTEE’s e-newsletter.