In a pyrrhic victory for plaintiffs, the California Court of Appeal has held that an Option ARM class action survives the pleading stage. See Boschma v. Home Loan Center, Inc. (August 10, 2011) — Cal.Rptr.3d —, 2011 WL 3486440. This is the first published California case to address Option ARM cases in such detail. These cases are part of the wave of mortgage litigation flooding the courts in recent years.
In Boschma, as in similar cases, the plaintiffs complain that disclosures pertaining to the payment options of their Adjustable Rate Mortgage loans are misleading. In particular, they complain that following one or more of the payment options will lead to negative amortization—the monthly payments will be so low that they will not keep up with the interest charged, so that the balance owed actually increases over time, rather than decreases. The loan disclosures specifically state that, depending on the payment option chosen by the borrower, negative amortization may occur. Nevertheless, plaintiffs complain that such disclosures are confusing, and therefore unfair, fraudulent, and unlawful.
In Boschma, the plaintiffs sued their lender, Home Loan Center, Inc. for fraudulent omissions and violation of Business and Professions Code Section 17200 et seq. ("Section 17200"). The trial court sustained the lender’s demurrer without leave to amend – noting that the loan documents repeatedly warned of the possibility of negative amortization. Noting the very liberal pleading standard, however, the Court of Appeal reversed.
While giving plaintiffs a chance to fight another day, the Court’s holdings show that any such fight will be short lived. The Court expressed serious doubts about whether plaintiffs could ever prove their allegations, much less certify a class.
To begin with, the Court did not find the written disclosures misleading as a matter of law, and noted the many warnings about the possibility of negative amortization. According to the Court, "the mere fact that borrowers took out Option ARMS does not necessarily prove they were misled by disclosures." The court then went on to list several real-world examples of situations where a borrower would intentionally seek out an Option ARM loan given the advantages such loans provide. To prove liability, plaintiffs will need to establish that they actually read the disclosures, that those disclosures were fraudulent, and that the plaintiffs were misled by the disclosures to their detriment.
The Court also emphasized the difficulty plaintiffs will have in proving damages. It held that negative amortization, in and of itself, does not constitute damages. The court noted that in exchange "for gradually declining equity, plaintiffs retained liquid cash that they otherwise would have paid to defendant (or another lender)." Justice Rylaarsdam was even more forceful in his concurring opinion: "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 not constitute damages." Instead, to show damages plaintiffs will need to prove that they would have obtained a different, "better" loan were it not for the purportedly misleading disclosures.
The decision also shows how difficult, if not impossible, it will be to certify a class of Option ARM borrowers. As the Court appears to suggest, detrimental reliance cannot be universally inferred from the disclosures themselves. Indeed, most borrowers probably never read the written disclosures. What they may have been told about the terms of the loan will of course vary from borrower to borrower. The motivations of the borrowers in obtaining Option ARM loans will also vary. Damages will also vary, as each putative class member would have to show he or she would have obtained a "better" loan were it not for the purportedly misleading negative amortization disclosures.
In sum, clever class counsel may be able to artfully plead an Option ARM claim to survive a challenge at the pleading stage. As the Court in Boschma makes clear, however, proving such allegations and certifying Option ARM classes will be very difficult.