This case in point explores the doctrine of unconscionability, a judicially created shield against predatory lending, as viewed through the recent case decision, Lona v. Citibank.
Homeowner’s claim of unconscionable refinancing upheld
Facts: A homeowner refinanced his property for an amount well beyond a sustainable debt-to-income (DTI) ratio. The homeowner promptly defaulted on his loan and the lender foreclosed, acquiring title to the property as the high bidder at the trustee’s sale.
Claim: The homeowner sought to set aside the trustee’s sale, claiming the loan was invalid as it was unconscionable since his income was so low it was impossible to make loan payments and he did not understand the loan documents he signed due to his limited English abilities.
Counter claim: The lender defended the trustee’s sale as valid, claiming the homeowner voluntarily entered into the loan transaction.
Holding: A California appeals court held the owner had the right to proceed with an action to set aside the trustee’s sale on proof the loan was unconscionable since there was evidence of unequal bargaining power held by the lender and lender oppression sufficient to allow a court to determine whether the loan was unconscionable. [Lona v. Citibank (2011) 202 CA 4th 89]
Unconscionable loans are unenforceable
The doctrine of unconscionability attempts to codify a nebulous, somewhat subjective concept which is nonetheless the result of predatory lending. It asserts a contract’s lack of fairness or reasonableness may outweigh the fact a borrower has signed on the dotted line, committing himself to the loan terms.
Loans originated under predatory circumstances can be deemed unconscionable, resulting in an unenforceable note and trust deed, or a trust deed note which may be partially enforced after the court’s removal of the unconscionable terms and conditions. In the Lona rule, a loan deemed unconscionable results in an unenforceable trust deed. [Calif. Civil Code §1670.5]
Loans resulting from predatory lending create a high probability of borrower default, as the borrower often either does not understand the loan terms or is led to believe false information about their ability to make payments. There are various types of predatory lending, and the inevitable result is an insolvent borrower (which depresses the economy).
Contract of adhesion
Conceptually related to predatory lending, a contract of adhesion is an agreement in which one party has a dramatically superior bargaining strength, such as an institutional lender always has. The agreement limits the other party to the extent he has no bargaining power, forcing him to either accept the agreement’s terms as is or reject all terms – a dynamic present to some degree in all lender/borrower relationships, particularly if a loan application was only submitted to one lender. [AT&T Mobility LLC v. Concepcion (2011) 563 U.S. __]
A contract of adhesion is considered unconscionable if:
- the lender attempts to enforce terms not falling within the weaker party’s reasonable expectations (a procedural element based on oppression and surprise); or
- the loan terms meet all reasonable expectations of the weaker party but is unduly oppressive (a substantive element based on the exceedingly harsh terms of the contract).
Both the procedural and substantive elements must be present for a contract to be deemed unenforceable via the doctrine of unconscionability. [CC §1670.5; Armendariz v. Foundation Health Psychcare Services, Inc. (2000) 24 Cal.4th 83]
Unconscionable loans are invalid from the very inception of the loan. Thus, a trustee’s sale conducted on an unconscionable loan is considered void. The doctrine of unconscionability was codified in 1979 with the intent to protect weaker parties trapped by unconscionable loans from the inevitable (and unconscionable) result, though the defense has been recognized under English common law since the 18th century. [Earl of Chesterfield v. Janssen (1790) 28 Eng Reprint 82]
The case at hand
The loan in Lona had a stratospheric debt-to-income (DTI) ratio for the homeowner. Despite the homeowner’s annual income of $40,000 and no other wealth, the lender approved him for a $1.5 million loan. Thus, as a matter of mathematical certainty, the borrower was pre-destined to default. Further, the refinancing had a fixed interest rate of 12.25%.
Further, the homeowner possessed an eighth grade education and was minimally conversant in English. The loan documentation was written only in English, with no verbal or written translation provided.
The agent’s duty
The buyer’s or owner’s agent is first in the line of defense to prevent predatory lending. When representing a buyer or homeowner seeking a mortgage, their agents must be aware of the potential of predatory lending as imposed by their fiduciary duty owed to the client and part of their role as gatekeeper to real estate ownership.
In particular, agents need to advise their clients to be especially aware that adjustable rate mortgages (ARMs) are the most frequently used tool in the predatory lender’s toolbox. ARMs are inherently mathematically complex and come equipped with an enticing teaser rate and payments which have no relationship to the rate and payments required to amortize the loan.
As good practice, encourage borrowers to shop around for the best loan. They will be most pleasantly surprised.