RPLR July 2016


Liability for Negligent Loan Modifications

Roger Bernhardt


Daniels v Select Portfolio Servicing, Inc.


In Daniels v Select Portfolio Servicing, Inc. (2016) 246 CA4th 1150, the Sixth District held that a loan servicer owed a duty of care to borrowers, which it then breached by clumsily handling their loan modification application. (See p 97 for a more complete description of this case, including its numerous other issues.) That particular holding created an exception to the oft-stated rule that no duty of care is owed in a real estate financing transaction by a participant whose involvement in it is strictly conventional. Because eight causes of action were asserted against four defendants, many of which were analyzed in the court’s opinion, there is much more in the case; however, the negligence claim against the servicer was the most interesting. Its attraction lies not in making readers wonder whether this servicer’s behavior fell below any standard of care—it clearly did, if the borrowers’ allegations are taken to be true—but rather in contemplating whether the servicer owed these borrowers any duty of care at all.


Rival Rules


Our courts have not made life easy for litigators in this area of financial negligence. They have held, on the one hand, that the general rule is that everyone owes a duty of reasonable care when engaging in conduct that might harm others. “[N]egligence is conduct which falls below the standard established by law for the protection of others against unreasonable risk of harm.” Restatement (Second) of Torts §282 (1965). (I’ll call this rule “general” because it does not appear to include any restrictive qualifications.)


But that rule has been qualified by a different rule for the banking industry: A financial institution owes no duty of care to a borrower if its involvement did not exceed the conventional scope of being a “mere lender of money.” Nymark v Heart Fed. Sav. & Loan Ass’n (1991) 231 CA3d 1089, reported at 14 CEB RPLR 270 (Oct. 1991). See Miller & Starr, California Real Estate §35:4 (4th ed 2015). The same is also true for a lender’s agents, including loan servicers, whose duties usually include modifying loans for distressed borrowers. Lueras v BAC Home Loans Servicing, LP (2013) 221 CA4th 49, 67 (“a loan modification is the renegotiation of loan terms, which falls squarely within the scope of a lending institution’s conventional role as a lender of money”).


This distinction between the general duty of care whenever harm is foreseeable and a particularized nonduty of care for conventional lending activities means that counsel for aggrieved borrowers need first to show that the situation does not involve dealings by an ordinary lender in a run-of-the-mill transaction. (Miller & Starr (§35:2) reads the cases to add a possible third rule by saying there may be no duty to offer a loan modification to a troubled borrower but there is a “limited duty of care” in processing her application for a modification. But that complicating distinction is one I will not make again in this column.)


Biakanja Factors


Daniels blurs the picture even further by holding that even when borrowers do not fall on the good side of the above distinction, they may still be able to establish that a duty of care is owed by relying on the factor test of Biakanja v Irving (1958) 49 C2d 647, thus creating a secondary route to lender liability. In Biakanja, our supreme court held that a notary public who misdrafted a will could be liable for economic loss to the intended legatee, even in the absence of privity (the notary had been hired by the testator), after considering six features of the transaction, which are described below. This factor test was later used by the supreme court in Connor v Great W. Sav. & Loan Ass’n (1968) 69 C2d 850 to hold a construction lender potentially liable to remote purchasers of the shoddily constructed residences that had been financed by its funds.


The Daniels court then applied this factor test to reach the conclusion that the servicer in this modification situation owed a duty of care (and had probably breached it). That logic complicates the picture for trial counsel, who may now have to work their way past the general duty rule, through the conventional lending no-duty rule, and then into a Biakanja factor analysis. (This Biakanja test was also applied in Jolley v Chase Home Fin., LLC (2013) 213 CA4th 872, reported at 36 CEB RPLR 46 (Mar. 2003), to hold that a construction lender did owe a duty of care to a nonresidential borrower in dealing with his requests for a modification, but most other courts have declined to follow that decision. On Jolley, see my column The Future of Foreclosure (36 CEB RPLR 59 (May 2013)), reprinted at RogerBernhardt.com.)


As a real estate lawyer, I am usually most interested in what the transactional documents say, being generally uncomfortable having to deal with the policy considerations that pervade traditional tort analysis. I don’t know how one predicts where a Biakanja analysis will lead (or how to write documentary provisions making that answer more predictable). To illustrate my discomfort, I offer the opinions in Connor v Great W. Sav. & Loan Ass’n, supra, itself. On the question of whether the Biakanja standards led to a conclusion that the construction lender owed a duty of care to remote purchasers of poorly built houses under those standards as applied, Justices Traynor and Mosk—two quite intelligent and experienced jurists—hardly saw eye-to-eye, reaching radically different interpretations of each factor, as detailed below.


Intent to Affect


On the first factor—the extent to which the transaction was intended to affect plaintiffs—Justice Traynor opined that “the success of Great Western’s transactions with [the developers] depended entirely upon the ability of the parties to induce plaintiffs to buy homes ... and to finance the purchases with funds supplied by Great Western” (69 C2d at 866)—thereby seeming to say that the construction loan was intended to affect these buyers—whereas Justice Mosk thought “[t]here can be no question that the transaction was intended to affect the lender and the borrower, and was not for the benefit direct or indirect of plaintiffs.” 69 C2d at 877 (emphasis added). Both justices appear to have believed that the intent-to-affect factor was an appropriate one to consider, but then completely disagreed as to where it led. Under that cloud of uncertainty, how does an attorney go about preparing to persuade an ordinary judge about the issue of the defendant’s intent to affect the plaintiff in her case? Do you need better evidence, or stronger arguments, or just prayer?


The Daniels court said that the loan modification involved there was “unquestionably” intended to affect the borrowers, and probably even Justice Mosk would have agreed with that conclusion under these facts (in which the servicer and borrower negotiated with each other). However, in Lueras v BAC Home Loans Servicing, supra, the same Fourth District had earlier held that a servicer did not have a duty to “offer, consider, or approve a loan modification” because that is merely “the renegotiation of loan terms, which falls squarely within the scope of a lending institution’s conventional role as a lender of money”—thereby putting the modification situation under the conventional lending exception rather than within the alternative Biakanja factors analysis. Given those contrasting judicial approaches, how does counsel argue that one test is better than the other? (The Lueras court itself went on to apply the Biakanja factors, notwithstanding what it had said—a matter I will discuss below.)




On the second factor—foreseeability of harm—Justice Traynor believed that because the lender knew the borrower was thinly capitalized, there was “a readily foreseeable risk that it would be driven to cutting corners in construction” (69 C2d at 866 (emphasis added)), whereas Justice Mosk wrote, “It is scarcely foreseeable by the lender, as a result of simply providing funds for construction, that gross structural defects would exist in the homes ultimately constructed by the builder” (69 C2d at 877 (emphasis added)). How useful is foreseeability as a test in light of this total judicial disagreement about its application in this situation, when no facts seemed in dispute? What evidence could counsel offer to make his or her position more palatable than the other to the judge?


The Daniels court held that harm was readily foreseeable because the borrowers’ credit rating would be adversely affected by any servicer mishandling of the documents. In Lueras, on the other hand, the court did not even discuss foreseeability, implying that the lack of a close connection or moral blame (two other Biakanja factors) was enough to make the others irrelevant. Does that mean a defendant who is able to show that the critical connection is distant and/or that the conduct was blameless has made out a complete defense, despite plaintiff’s proof of foreseeability? Do you know how to prepare for foreseeability?


Certainty of Injury


Justice Traynor found the third factor—certainty of plaintiff’s injury—satisfied because the houses were indisputably defective, but Justice Mosk thought, instead, that the issue was “whether liability for that injury is to be imposed on the nearest solvent bystander or upon the party whose negligent conduct produced the injury.” 69 C2d at 878. (This disagreement sounds more like one over cause than certainty of harm, but either way, if its outcome depends on the choice of which fact a judge should look at (that the financed houses were defective or that they were defectively constructed), trial preparation will surely be more uncertain.)


That disagreement may not have been as relevant in Daniels (where there was clearly no remoteness between the borrowers and the servicer). That court rejected defendants’ contention that injury was uncertain absent any evidence that plaintiffs would have qualified for a modification and held that the impairment of plaintiffs’ credit ratings and costs incurred by them was good enough. Lueras did not discuss this factor. In general, it will probably always be the case that borrowers who litigate will have suffered some injury that led them to file suit (e.g., foreclosure or remaining subject to an onerous loan). Counsel must hope that injury is the right one.


Close Connection


Justice Traynor found the fourth factor—closeness of the connection between defendant’s conduct and plaintiff’s injuries—was met, saying that if Great Western had used “reasonable care in the exercise of its control” it would have discovered the defects in the plans. 69 C2d at 867. Justice Mosk, on the other hand, believed that construction and lending “have no ‘closeness of connection’” and “are significantly remote.” 69 C2d at 878. A conclusion by one judge that a transaction is closely connected to another, when his colleague finds it to be remote, gives little guidance to the rest of us.


The Daniels court finessed this Traynor/Mosk gulf by finding a connection between the borrowers’ injuries and the servicer’s “stringing appellants along with promises” (although this sounds to me more like recharacterizing negligence into misrepresentation). Daniels v Select Portfolio Servicing, Inc. (2016) 246 CA4th 1150, 1183. The Lueras court, in its own way, took the same tack, holding “[i]f the modification was necessary due to the borrower’s inability to repay the loan, the borrower’s harm, suffered from denial of a loan modification, would not be closely connected to the lender’s conduct”—thereby switching the focus from the servicer’s treatment of the modification application to the borrowers’ preexisting need for the modification. Lueras v BAC Home Loans Servicing, LP (2013) 221 CA4th 49, 51. Since modifications are frequently requested by borrowers who are already in trouble, there will always be this question of whose behavior to concentrate on, with little judicial help in deciding.




The fifth factor is blameworthiness of defendant’s conduct. Justice Traynor concluded that blame existed because the lender did not meet its obligations, to either its own shareholders or to the buyers, to supervise construction—whereas Justice Mosk believed that the lender’s “only responsibility” was to its shareholders and not to the buyers. 69 C2d at 878. I don’t quite see how either position tells us much about blameworthiness, but I do know unclarity makes it difficult for attorneys to calculate what evidence or argument they should employ to persuade a court of who was blameworthy (or even if that is the right question).


The Daniels court held the blameworthiness factor to be neutral in its case, as well as unpredictable from the pleadings, because there was some defendant fault (encouraging plaintiffs to default), but also some plaintiff fault (coming so close to defaulting anyway). The Lueras court, on the other hand, concluded “[i]f the lender did not place the borrower in a position creating a need for a loan modification, then no moral blame would be attached to the lender’s conduct” (221 CA4th at 67)—a position that clearly makes any subsequent blameworthiness by the servicer in the negotiations irrelevant because of its noninvolvement in causing the borrower’s original distress. In trials, plaintiff’s counsel can be expected to stress the bad nature of defendant’s treatment of its modification request, while the defendant will focus on the plaintiff’s earlier need for relief, each hoping the court will pay more attention to its preferred factor, but with little certainty as to the result.


Preventing Harm


Justice Traynor seems to have merely waved away the final factor—preventing future harm—saying that “[r]ules that tend to discourage misconduct are particularly appropriate when applied to an established industry.” 69 C2d at 867. Justice Mosk contrarily believed that such rules “intended to deter or minimize the risk of future harm are imposed only upon those creating and controlling the risk of harm.” 69 C2d at 878. As before, we don’t know what sort of evidence would persuade the next judge to choose one view over the other.


Daniels and Lueras are not helpful here (Daniels having held this factor worked both ways, giving lenders an incentive to handle modifications “in a timely and responsible manner” but also deterring them from offering modifications, and Lueras not even mentioning the factor).


The Outcome


Making deals is much easier than litigating them: Both sides know what language helps rather than hurts and need only persuade their counterparty to agree to it or to compromise on it. When they litigate instead, especially in a tort context, each must prepare to persuade their judge of the wrongness of the opponent and why to choose their preferred rule (e.g., care to everyone if harm is foreseeable, or no care to anyone if the lending is conventional, or “care or no care” decided by balancing the Biakanja factors). Then, if they are under those Biakanja factors (to decide how to convince the judge as to intent to affect plaintiff, foreseeability of harm, certainty of injury, close connection, blameworthiness, and prevention of harm), none of these factors is very intelligible anyway (see Traynor v Mosk, or Daniels v Lueras), and none of us seems to know what to do when the balancing comes out close (e.g., three factors for plaintiffs and three for defendants). Lawyers have little to tell them how such fights will resolve themselves, probably meaning little reason to reject the claims (or defenses) of either party in advance, although perhaps giving them a stronger incentive to settle.




39 Real Property Law Reporter 89 (Cal CEB July 2016), © The Regents of the University of California, reprinted with permission of CEB.