A recent, important decision from California’s Supreme Court clarifies lender liability in connection with servicing loans in default and limits a homeowner’s ability to assert tort claims against lenders and loan servicers. In Sheen, the California Supreme Court unanimously ruled that lenders and their servicers do not owe borrowers a duty to “review and respond carefully and completely” to a loan modification application. The decision resolves a split among California’s courts, and federal courts applying California law, as to whether such a duty exists.
In Sheen, the borrower used his home as collateral for a second, junior loan with a major bank. The borrower fell behind on his payments, and the bank recorded a notice of default on the property. Following this default, in 2010, the borrower submitted a loan modification application that prompted the bank to cancel further foreclosure activity. The plaintiff alleged that the bank never sent him a decision regarding the application. The loan was later sold to a third party and assigned to a new loan servicer. Four years later, the loan’s new owner foreclosed on the property. The borrower subsequently sued the bank, alleging that the bank negligently handled his 2010 loan modification application.
At the trial court, the bank successfully moved to dismiss the complaint arguing that there is no independent tort duty when handling a loan modification application. California’s Court of Appeals for the Second Appellate District affirmed the decision. Recognizing that “the issue of whether a tort duty exists for mortgage modification has divided California’s courts for years,” California’s Supreme Court agreed to hear the borrower’s challenge to the lower courts’ rulings.
The California Supreme Court explained that because a request for a loan modification is an attempt to renegotiate an existing loan, it falls “within the scope of the parties’ contractual relationship” and is subject to the economic loss rule, which generally prohibits negligence claims where there is an existing contract between the parties. In reaching this decision, the Court rejected the reasoning of lower courts that had relied on the multi-factored test articulated in a previous California Supreme Court decision, Biakanja v. Irving, to find the existence of a tort duty in the loan modification context. The Court explained that the test for the existence of a tort duty articulated in Biakanja was intended to apply where the parties “were not in privity[.]” (emphasis in original). A borrower seeking to modify an existing loan is necessarily in privity with their lender or loan servicer, so Biakanja is not implicated.
The Court also expressed reluctance to impose “a duty that appears to cover everything the lender does during the pendency of a loan modification application” because such a duty “would be difficult to adjudicate in any clear and consistent way[.]” The Court recognized that both federal and state regulations already imposed certain obligations on lenders and loan servicers when handling requests for loan modifications, so imposing an additional tort-based duty atop actions “already covered” by such regulations was unnecessary. Finally, the Court observed that the “cost of servicing” a mortgage in default “was 15 times higher than the cost of managing one that is not in default,” and so imposing additional duties on lenders “will likely raise the cost of providing that service,” presenting a policy trade-off that was more appropriately made by the legislature than the courts.
While Sheen makes it clear that, in California, lenders do not owe borrowers a duty of care when handling requests for loan modifications, the California Supreme Court was careful to note that its decision did not necessarily preclude other tort or tort-like theories in connection with a loan modification.
Sheen joins a growing list of state supreme court decisions finding that there is no tort duty of care owed to a borrower who has applied for a loan modification. Moreover, Sheen reaffirms the general proposition that a “financial institution owes no duty of care to a borrower when the institution’s involvement in the loan transaction does not exceed the scope of its conventional role” as a lender. Since the decision is not necessarily limited to claims involving loan modifications, it potentially provides a forceful defense to negligence claims asserted against financial service providers in a variety of settings.