Until recently, a mortgage lender preparing to give a loan needed only to conduct a basic search of the title and records of the subject property. A lender was not required to search into the background and financial status of a borrower to ensure that the borrower was legitimate and would be able to repay the loan. As long as the borrower had recorded title and there were no senior recorded liens or notices of pendency, the lender was free to give out such loans knowing its interest in the property was protected. The lender was what is referred to as a “bona fide encumbrancer for value,” which meant that if the borrower’s ability to repay had been overstated and/or if the transaction was tainted by outright fraud, the lender’s interest in the property was still secure.
Beginning in 2008, the United States became mired in a foreclosure crisis, and huge numbers of homeowners were stuck with loans they could not repay. This had a disastrous snowball effect on the economy. It also opened the door to widespread foreclosure rescue schemes, in which scam artists induced homeowners who faced foreclosure to convey title by falsely promising to help them refinance. In response, the federal government enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act Ability –to-Repay/Qualified Mortgage (“Dodd-Frank”) amendments to the Truth in Lending Act (TILA), designed to protect borrowers from entering into risky loan agreements, and many States also enacted similar legislation.
The new federal and State legislation not only imposes a new duty upon all lenders to verify the ability of their borrowers to repay the loans, but also creates a duty for lenders to investigate situations that arouse suspicion about the integrity of the borrowers. In such cases, if a lender fails to investigate, the lender may not be entitled to “bona fide” status, and, if it makes the loan, its interest in the property will not be protected. Moreover, the federal government requires bank mortgage lenders to file suspicious activity reports (SARs) if signs of a foreclosure rescue scheme or other fraudulent activity is suspected.
Although both the new federal and State regulatory schemes are well intentioned, the new rules do not apply to the overwhelming majority of borrowers otherwise qualified to apply for loans, and, therefore, the loan market is only marginally affected by the lenders’ new duty to investigate their borrowers’ ability to repay. Under the Dodd-Frank amendments, TILA requires mortgage lenders to verify a borrower’s ability to repay for only a small subset of particularly risky loans. Eight states have enacted legislation that mirror the federal approach and limit the duty of lenders in those states to investigate only certain specified categories of risky loans. Just twelve states and the District of Columbia require lenders to determine a borrower’s ability to repay in connection with all mortgage loans. Despite the limited scope of mortgage loans generally affected by the new legislation, the new rules are a fact of life to which lenders must adapt their loan application processes.
For this article, using the search term “lender duty to investigate” on Westlaw, we reviewed the legislation of the 22 states that have ability-to-repay requirements and also the recent court decisions of nine states that have addressed a lender’s duty to investigate suspicious transactions. We also looked at relevant federal laws and regulations. Our research shows that there is a variety of different approaches being implemented in this area, but nevertheless a general trend toward an increased duty for lenders to know their borrowers. The observance of this duty by lenders will protect their interest in ensuring the repayment of their loans, either by the borrowers in accordance with specified mortgage terms, or upon issuance of court judgments obtained in any necessary foreclosure proceedings.
The Federal Approach
Congress passed the Dodd-Frank amendments in 2010 in the wake of the financial crisis as a way to prevent the kind of predatory lending practices that were at the root of the problem. See CFPB Fact Sheet. The act, as implemented through Regulation Z of the Code of Federal Regulations, requires lenders to verify a buyer’s ability to repay respecting certain types of particularly risky loans – interest-only loans, loans with balloon payments, loans whose principal increases over time, and loans for a period of more than 30 years. See 12 C.F.R. §1026.43. However, the vast majority of loans – 92 percent according to the Consumer Finance Protection Bureau – meet the requirements of a “Qualified Mortgage” as defined in TILA. See CFPB Fact Sheet. In addition, loans sold to FANNIE MAE and FREDDIE MAC are presumptively Qualified Mortgage eligible, except as to matters wholly unrelated to ability to repay. Similarly, loans sole to HUD, the VA, and the Department of Agriculture, are also presumptively Qualified Mortgage eligible for transactions consummated on or before January 10, 2021, or on such other date as each agency may designate under its own regulations.
In addition to not containing any of the risky features listed above, a loan meets the requirements of a Qualified Mortgage if the lender complies with certain basic underwriting requirements, such as calculating monthly payments based on the highest payment that will apply in the first 5 years. See 12 C.F.R. §1026.43. For a Qualified Mortgage with a higher than average interest rate, there is a rebuttable presumption that the lender has complied with the ability-to-repay requirements of Regulation Z. For all other Qualified Mortgages, there is a conclusive presumption that the lender has satisfied the requirements of Regulation Z. Id.
States With Requirements Similar to the Federal Approach
Several states have enacted ability-to-repay requirements that are similar to the federal approach in that they apply only to a small subset of particularly risky loans. Oregon has an ability-to-repay provision limited to negative amortization loans, or those in which the principal increases over the duration of the loan.SeeOr. Rev. Stat. Ann. § 86A.195 (West). Kentucky, Tennessee, Rhode Island, and South Carolina require lenders to verify a borrower’s ability to repay solely for “high-cost” mortgage loans. Ky. Rev. Stat. Ann. § 360.100 (Baldwin); Tn. Code Ann. § 45-20-103 (West); R.I. Gen. Law. Ann. § 34-25.2-6 (West); S.C. Code of Laws Ann. § 37-23-40 (West). These states define “high-cost” to mean a loan with an interest rate or points and fees that exceed a certain threshold. KRS § 360.100; T. C. A. § 45-20-102; Gen. Laws § 34-25.2-4 S.C. St. § 37-23-20. North Carolina similarly has an ability-to-repay requirement for “rate spread” loans, which are defined as mortgage loans with an above-average interest rate. N.C. Gen Stat. Ann.. § 24-1.1F (West). Although these provisions encompass more potential loans than the federal law, overall they are still limited in scope, and they do not impose a general duty upon lenders to ensure that all their borrowers can repay their loans.
States With Stricter Requirements Than the Federal Approach
In contrast, twelve states and the District of Columbia have legislation imposing ability-to-repay requirements on all mortgage loans, regardless of size or type. (For a complete list of states, see the attached chart). In addition, although New York has no statutory requirement that lenders verify a borrower’s ability to repay, the New York State Supreme Court Appellate Division, First Department, recently imposed such a duty for all mortgage loans, at least where the lender is aware of other facts that should arouse suspicion about the transaction. Miller-Francis v. Smith-Jackson, 113 A.D.3d 28, 976 N.Y.S.2d 34 (1st Dept. 2013). In Miller-Francis v. Smith-Jackson, the Court held that, where a mortgage lender had a borrower who did not sign any documents until the closing and who, at the closing, appeared to not understand the transaction being entered into, the lender had a duty to review the borrower’s “paystubs, tax returns, or credit history” to ensure that the borrower was in fact able to repay the loan. Id.
Examples of some state legislation imposing ability-to-repay requirements on all mortgage loans are:
In addition to these States, Minnesota, Massachusetts, Colorado, Hawaii and New Hampshire also have statutes requiring lenders to verify a borrower’s ability to repay for all mortgage loans. Minn. Stat. Ann. §58.13(a)(24); 940 Mass. Code Reg. §8.06(15); Colo. Rev. Stat. Ann. §38-40-105(1.7)(a); Haw. Rev. Stat. Ann. §454F-17(a); and N.H. Rev. Stat. Ann. §397-A:15(X).
California and West Virginia reach a similar result through a slightly different approach. No statutes impose an affirmative duty to verify a borrower’s ability to repay, and California courts have expressly held that lenders have no general duty to verify a borrower’s ability to repay. See Castro v. Aurora Loan Servs., LLC, B247114, 2014 WL 2446719 (Cal. Ct. App. June 2, 2014); Perlas v. GMAC Mortgage, LLC, 187 Cal. App. 4th 429 (2010) (“A lender is under no duty to determine the borrower’s ability to repay the loan … The lender’s efforts to determine the creditworthinesss and ability to repay by a borrower are for the lender’s protection, not the borrower’s,”). Nevertheless, in both states, a lender can have its license revoked if it is shown that the lender has repeatedly made loans to borrowers who cannot afford to repay the loans. See Cal. Fin. Code Ann. § 22714 (West); W.V. Code. § 31-17-12 (West). In effect, although California and West Virginia lenders have no affirmative duty to verify their borrowers’ ability to repay (except in California for certain loans with higher than average interest rates, points, or fees, see Cal. Fin. Code Ann. § 22714 (West)), lenders in those states, who do not verify the ability of all borrowers to repay their loans, do so at great risk.
In addition to the requirement to verify a borrower’s ability to repay, lenders may also need to investigate potential issues with the borrower or transaction if they are aware of certain facts that should arouse suspicion. Otherwise, a lender may not be entitled to “bona fide” status and its interest in the property will not be protected. Recent court decisions in nine states have addressed this issue, and the courts in those states have taken various positions on whether the duty exists, and if so, what facts are sufficient to trigger the duty.
Of the nine states that have addressed the issue, four states — New York, California, Texas, and Minnesota — have held explicitly that, if the lender is aware of certain facts which suggest that the transaction is suspicious, the lender has a duty to investigate further. Miller-Francis v. Smith-Jackson, 113 A.D.3d 28, 976 N.Y.S.2d 34 (1st Dept. 2013); Johnson v. Deutsche Bank Nat. Trust Co., No. B223188, 2011 WL 3675691 (Cal. Ct. App. Feb. 13. 2014); In re Harydzak, 406 B.R. 499 (Bankr. S.D. Tex. 2009); Stella v. Wells Fargo Bank, N.A., No. A11–1827, 2012 WL 3553123 (Aug. 20, 2012). A fifth state, Florida, declined to decide whether such a duty exists. Ocean Bank of Miami v. Inv-Uni Inv. Corp., 599So.2d 694 (Dist. Ct. App. 1992).
An Illinois court recently held, however, that a mortgage lender faced with a potentially problematic transaction had no further duty to investigate and was protected because it had conducted a basic search of the title and records. Stump v. Swanson Development Co., LLC, 5 N.E.3d 279 (Ill. App. Ct. 2014). The case involved a business venture between two individuals, Stump and Swanson, in which the two agreed to purchase and develop several properties. Swanson obtained a loan against one of the properties and allegedly spent all of the money fraudulently on himself rather than for the business venture. Swanson subsequently defaulted and the lender foreclosed. Stump brought suit to assert title to the property contending that the lender should not be entitled to bona fide status because it ignored signs of the fraud and failed to further investigate. The court rejected the argument, holding that the lender had no duty to investigate because
even though all of [the bank’s] policies were not carefully followed, the bank adequately protected its interests by commissioning a title search which disclosed no clouds on title, ascertaining that the appraised value of the collateral equaled or exceeded the amounts of the loans it was making, and assuring itself that its lien stood in first position.
The court further stated that any failure to adequately investigate prior to underwriting the loan might have been a breach of duty to the bank’s shareholders, but did not eliminate the lender’s bona fide status.
New Jersey similarly has held that a lender presented with facts that raised suspicion about the transaction had no further duty to investigate and was entitled to take the transaction at face value. Family First Federal Sav. Bank v. DeVicentis, 665 A.2d 1119 (Sup. Ct. N.J. Appellate Division 1995). In a foreclosure action, the defendant contended that she did not fully understand the transaction when she entered into the transaction and that she was fraudulently induced by her husband. She argued that the bank should have been put on suspicion by the fact that she was an elderly woman and that she showed up to the closing without a lawyer while the other parties had one. The court rejected the defense, holding
when an elderly mortgagor appears at a mortgage closing with an adult son for whose benefit the mortgage is being given and who is a co-signor of the mortgage note, and when they appear with an attorney apparently acting for both, the bank is entitled to accept what appears to be a perfectly routine and unexceptionable transaction at face value without intruding itself into the parental or the legal relationships involved.
Likewise, the Nevada Supreme Court also recently held, in a case brought by a victim of identity theft, that lenders owe no duty to investigate problematic transactions. Davenport v. GMAC Mortg., No. 56697, 2013 WL 5437119 (Sept. 25, 2013).
Similarly, in 1993, a Massachusetts appellate court held that a lender is under no duty . . . to exercise due care in dealing with the borrower or determining whether to make the loan.” Shawmut Bank N.A. v. Wayman, 34 Mass.App.Ct. 20 (App. Ct. Mass. 1993). However, in the interim since 1993, no other Massachusetts appellate court decisions have addressed the issue, but recent Massachusetts trial court decisions, citing New York and California cases, have held that the lender may have a duty to investigate when aware of sufficient facts that arouse suspicion. Provident Funding Associates LP v. Jones, 31 Mass.L.Rptr. 37 (Superior Ct. 2013); Henry v. Provident Funding Assoc. L.P., 30 Mass.L.Rptr. 33 (Superior Ct. 2012)
For those states that have imposed a duty to investigate, the question remains what facts are sufficient to trigger the duty? A review of recent cases from New York, California, Texas, and Minnesota suggest that there is as yet no “bright line” rule by which one may predict when a court will decide that the duty has been triggered.
In New York, appellate courts have decided two cases involving foreclosure rescue scams, and the decisions have reached opposite conclusions. Most recently, in Miller-Francis v. Smith-Jackson, the New York State Supreme Court Appellate Division, First Department, held that there were sufficient facts to trigger a duty for the lender to investigate. Miller-Francis v. Smith-Jackson, 113 A.D.3d 28, 976 N.Y.S.2d 34 (2013). In the case, Miller-Francis (“Miller”) was victim of a foreclosure rescue scheme. About to be foreclosed on, Miller was approached by Smith-Jackson (“Smith”), who told Miller that Smith could help Miller avoid foreclosure. Smith told Miller that Smith was helping Miller refinance, but Smith actually had Miller convey title to Smith. Smith then conveyed title to Henry, a third party who was not privy to the scheme. Henry’s sale was funded by a mortgage by Accredited. At the closing, it was apparent that Henry did not understand that he was purchasing a home. Contrary to normal practice, Henry did not sign the mortgage loan application until he was at the closing. Further, Accredited did not look at Henry’s pay stubs, tax returns, or credit history before approving his loan application. Moreover, the property was patently over-appraised, which Accredited apparently recognized because it reduced the amount of the loan. The court held that Accredited had a duty to further investigate the transaction (a) because these facts should have aroused suspicion that the transaction was tainted, and (b) because Accredited failed to obtain and review Henry’s pay stubs, and other materials prior to giving the loan, to ensure that Henry would be able to repay the loan.
Previously, however, in Mathurin v. Lost & Found Recovery, LLC, the New York State Appellate Division, Second Department, held that the facts pleaded regarding an alleged foreclosure rescue scam were insufficient to trigger a duty for the lender to investigate. 65 A.D.3d 617 (App. Div. 2d Dept. 2009). In that case, Mathurin was the victim of a foreclosure rescue scheme similar to the one in Miller-Francis. Mathurin was in danger of being foreclosed on and was approached by Lost&Found who said it could help Mathurin refinance, but actually tricked her into conveying title to a straw buyer, who then obtained a mortgage from the lender. Mathurin alleged that the lender (a) failed to take steps to verify that the borrower was not a straw buyer who would be able to repay the loan, and (b) failed to take steps to verify that Lost&Found was licensed to conduct refinancing services. The court held that the facts, as Mathurin pleaded them, although sufficient to survive a motion to dismiss, were nevertheless insufficient to trigger a duty by the lender to investigate the borrower.
Likewise, decisions in California, Texas, and Minnesota courts show that courts generally have not established any consistent rule for determining when the duty to investigate is triggered.
In Johnson v. Deutsche Bank Nat. Trust Co., a California appellate court held that the facts alleged regarding a foreclosure rescue scam were sufficient to survive a motion for summary judgment. No. B223188, 2011 WL 3675691 (Cal. Ct. App. Feb. 13. 2014). The court held that because (a) the property was conveyed multiple times in a short period of time, (b) the stated value of the property was steeply inflated, and (c) a prior owner was still in possession despite two intervening conveyances, these facts may have been sufficient to trigger the lender’s duty to further investigate before giving loan. Thus, the court held that there was a material dispute as to whether the lender was entitled to “bona fide” status.
In Ellis v. Golden Security Bank, a different panel of the same court held that the suspicious facts of an alleged fraudulent transaction were insufficient to give the lender a duty to investigate. No. B234992, 2012 WL 3860641 (Cal. Ct. App. Sept. 6 2012). In that case, while Kenneth was incarcerated, his wife, Cindy convinced him to give her a power of attorney purportedly to enable her to manage the property. She falsely said that she would manage the property, collect rents, and place them in a savings account for his benefit. Instead, Cindy attempted to obtain a loan on the property, but the lender refused to approve a loan because the power of attorney appeared to be defective. Cindy then prepared a new power of attorney and forged Kenneth’s signature. She also conveyed title to a friend’s dummy corporation as a “bona fide gift.” She subsequently obtained two separate loans against the property from two different lenders. She defaulted, and the lenders foreclosed. Kenneth brought an action to quiet title in which he contended that the facts (a) that the first loan was rejected, (b) that title was conveyed to a corporation as a gift, and (c) that there were two nearly identical powers of attorney executed a year apart should have given both lenders reason to suspect that the loan application was suspicious and that they had a duty to further investigate Cindy’s authority to act in his behalf. However, the court held that the lenders had no duty to further investigate and were entitled to “bona fide” status. The court explained that
Kenneth . . . fails to cite authority for the proposition that a lender is required to compare duly notarized signatures for suspected forgeries, or to investigate whether a corporate grantee is qualified to take property as a bona fide gift. We are aware of no authority imposing any such duties of inquiry and decline to create new law in this case imposing new rules about what might constitute constructive notice.
In a recent Texas case, the court held that the facts were sufficient to trigger a duty to investigate. In re Harydzak, 406 B.R. 499 (Bankr. S.D. Tex. 2009). This case also involved a foreclosure rescue scam. Harydzak, facing foreclosure, was approached by New Horizon who said it could help. New Horizon told Harydzak they were assisting in a refinancing, but actually tricked him into conveying title to New Horizon. New Horizon then obtained a mortgage from the lender. The lender granted the loan based on (a) outside counsel’s review of all relevant documents, including the public records from the county clerk’s office regarding the title and conveyances of the property, (b) on an oral appraisal of the property only, without a physical copy of the appraisal report, contrary to the lender’s own written procedure, and (c) without making any inquiry concerning numerous discrepancies contained in the appraisal report. The attorney also drafted a Consent by Beneficiaries form and had Harydzak sign this. The court held that the bank had a duty to investigate because the bank should have followed its standard written procedure and obtained the physical copy of the appraisal report in accordance with its standard procedure, concluding that the report would have alerted the bank to the suspicious nature of the transaction. The court further held the fact that the bank’s attorney had drafted a Consent by Beneficiaries form, which was not standard practice, was further evidence that the bank either knew or should have known that the transaction was problematic.
Minnesota courts have also issued opposite rulings on a lender’s duty to investigate. In Stella v. Wells Fargo Bank, N.A., an appellate court held that the facts of a mortgage dispute were insufficient to trigger a duty to investigate. No. A11–1827, 2012 WL 3553123 (Aug. 20 2012). The trial court initially ruled that there were sufficient facts, specifically that
(1) respondent had been in possession of the property since 1995, and was in possession as of the date of closing; (2) [bank] had knowledge that [borrower] did not intend to occupy the property; and (3) there were inconsistencies between the Settlement Statement, the loan transmittal documents, and the unsigned promissory note and mortgage regarding the loan . . . .
The appellate court reversed, holding that these facts were insufficient because, when property is registered in the Torrens system, there is no duty to inquire beyond the examination of the title certificate. In dictum, the court noted that even if there were a duty to inquire further based on suspicious facts, the facts alleged in the case were insufficient to place the lender on notice to inquire further. The court noted that it is not unusual for a borrower to not occupy the premises or for a seller to stay in possession until the date of closing, and that the documents containing the inconsistencies were not material to the mortgage transaction.
In contrast, in Claflin v. Commercial State Bank of Two Harbors, a Minnesota appellate court reversed a trial court finding that the facts were insufficient to trigger a duty to investigate. 487 N.W. 2d 242 (Minn. Ct. App. 1992). In this case, the borrower fraudulently convinced his mother to convey the title to her home to him, however he misrepresented the purpose of the transfer to his mother, he kept the transfer a secret from his wife, and he misrepresented his income on mortgage documents when he subsequently sought a mortgage on the property. The borrower’s fraud was eventually uncovered, and his mother sought to have the mortgage nullified. The appellate court held that several factors should have placed the mortgage lender on notice of the borrower’s fraud, including the fact that the borrower had immense credit card debt and that he incorrectly represented his income. As a result, the appellate court reversed the lower court’s decision, which had awarded a directed verdict to the mortgage lender, and instead awarded punitive damages to the mother.
In addition to the duty to investigate suspicious transactions in order to protect their interest in the mortgaged property, bank lenders are also required to file suspicious activity reports (SARs) if they come across signs of a problematic transaction. Recently, the Financial Crimes Enforcement Network of the Department of Treasury released a guide instructing banks to file SARs if they came across signs of foreclosure rescue scams. Fed.Banking L. Rep.P. 95-861 (C.C.H.), 2009 WL 8386762. The guide lists several common signs of a foreclosure scam, including the process being very quick and the borrower being pressured into signing paperwork they did not understand. These requirements do not apply to non-bank mortgage lenders.
The recent foreclosure crisis has led the federal government and many states to take steps that expand the responsibilities of a lender to investigate its borrower before giving a loan. Going forward, lenders should be aware of the developments in their particular state and make their loan decisions with all due prudence. As the review of the decisions discussed in this article clearly illustrates, unless lenders act with due diligence, lender action and/or inaction in connection with granting loan applications subjects them to possible loss of the security they bargain for in making loans to risky borrowers. While not all states impose a duty upon lenders to determine their borrowers’ ability to repay their loans, it is certainly prudent to do so, especially in light of the connection that may exist between the borrower’s inability to repay and the possible fraud that often underlies a transaction involving a risky borrower. Lenders must be comfortable that courts will enforce their signed loan documents and enforce judgments in foreclosure proceedings. While federal and state governments, as well as the courts, have required greater vigilance by lenders, they have at the same time provided a comfortable platform to allow lenders to be able to enforce payment and foreclosure on all but the riskiest loans.
*Adam Leitman Bailey is the founding partner of Adam Leitman Bailey, P.C., and John M. Desiderio is a partner at the firm. The authors wish to express their appreciation to Peter Budoff, a Third Year Brooklyn Law School student intern at the firm, who assisted in the research and writing of this article.
1 We used the search term “lender duty to investigate” on Westlaw.
2 CFPB Fact Sheet
3 12 C.F.R. § 1026.43
4 CFPB Fact Sheet
5 12 C.F.R. § 1026.43
6 12 C.F.R. § 1026.43
7 Or. Rev. Stat. Ann. § 86A.195 (West)
8Ky. Rev. Stat. Ann. § 360.100 (Baldwin); Tn. Code Ann. § 45-20-103 (West); R.I. Gen. Law. Ann. § 34-25.2-6 (West); S.C. Code of Laws Ann. § 37-23-40 (West).
9 KRS § 360.100; T. C. A. § 45-20-102; Gen.Laws § 34-25.2-4 S.C. St. § 37-23-20.
10 N.C. Gen Stat. Ann.. § 24-1.1F (West)
11 For a complete list of states, see the attached chart.
12 Miller-Francis v. Smith-Jackson, 113 A.D.3d 28, 976 N.Y.S.2d 34 (1st Dept. 2013).
14 Ill. Stat. Ann. § 635/5-6 (Smith-Hurd)
15 N.M. Stat. Ann. § 58-21B-13 (West)
17 Nev. Rev. Stat. Ann. § 598D.100 (West)
18 Ga. Code Ann. § 7-1-1013 (West);D.C. Code Ann. § 26-1014 (West)
20 Oh. Rev. Code Ann. § 1322.081 (Baldwin)
21 Mn. Stat. Ann. § 58.13 (West); 940 CMR 8.06; Colo. Rev. Stat. Ann. § 12-61-604.5 (West); Hi. Rev. Stat. Ann. § 454F-17 (West); N.H. Rev. Stat. Ann. § 397-A:15 (West).
22 See Castro v. Aurora Loan Servs., LLC, B247114, 2014 WL 2446719 (Cal. Ct. App. June 2, 2014); Perlas v. GMAC Mortgage, LLC, 187 Cal. App. 4th 429 (2010) (“A lender is under no duty to determine the borrower’s ability to repay the loan . . . The lender’s efforts to determine the creditworthiness and ability to repay by a borrower are for the lender’s protection, not the borrower’s,”).
23 Cal. Fin. Code Ann. § 22714 (West); W.V. Code. § 31-17-12 (West)
24 Cal. Fin. Code Ann. § 22714 (West)