California Supreme Court Says Lenders Owe No Duty of Care in Loan Modification Negotiations

The 2008 financial and foreclosure crisis—in addition to immiserating a generation of homeowners—led to an explosion in litigation against lenders and loan servicers by aggrieved owners.  Because of the volume of these cases and the diversity of approaches by the plaintiffs, a split of authority between the various Districts of the California Court of Appeal on a key issue developed: do lenders owe a duty of care in reviewing and processing loan modification applications? 

On March 7, 2022, in a unanimous, landmark (and whopping, 54-page) majority opinion authored by Chief Justice Cantil-Sakauye, the California Supreme Court answered that question with a resounding “no.”  In Sheen v. Wells Fargo, the Justices held that “lender[s] [do not] owe borrowers a tort duty sounding in general negligence principles to . . . ‘process, review and respond carefully and completely to a borrower’s loan modification application,’ such that upon a breach of this duty the lender may be liable for the borrower’s [solely] economic losses.”  (Slip Op. at 2.) On June 1, the Court denied Sheen’s petition for rehearing, effectively finalizing the Court’s decision.

In this case, borrower Kwang Sheen took out a second and third mortgage with Wells Fargo on his home in Los Angeles.  Sheen eventually missed payments on both loans and Wells Fargo began foreclosure proceedings, scheduling a trustee’s sale for February 2010.  In January of 2010, Sheen, through his representative, contacted Wells Fargo and applied for a loan modification in an attempt to stave off foreclosure.  A week after his application for modification, Wells Fargo cancelled the trustee’s sale set for February.  Wells Fargo never got back to Sheen directly about the loan modification requests, but did get a set of letters related to the two loans from Wells Fargo in March of 2010, which informed him the loans had been charged off and the balance accelerated.  Sheen interpreted these letters to mean that the loans had been modified to become unsecured such that there would be no foreclosure on his property.  However, as it turned out, Sheen’s interpretation of the letters was incorrect, and both loans remained secured as Wells Fargo went to the market with the distressed loans.

In November of 2010, Wells Fargo sold the second loan to a third party, and that loan eventually ended up in the hands of Mirabella Investment Group, LLC (“Mirabella,” a client of Gupta Evans & Ayres who prevailed against Sheen on summary judgment, plaintiff’s appeal of which is pending the resolution of the Wells Fargo appeal).  In 2014, Mirabella foreclosed on the property and it was sold at a foreclosure sale.  Sheen’s lawsuit followed, wherein he brought causes of action for intentional infliction of emotional distress, unfair competition (section 17200), and—most critically—negligence.  The California Court of Appeal held summarily dispatched the emotional distress and unfair competition claims, and, in the bulk of the opinion, held that Wells Fargo owed no duty of care to Sheen in processing his loan modification requests, relying on the “economic loss rule” which states that parties to a contract (or a contract negotiation) do not owe each other a duty not to cause purely economic losses that do not arise from the violation of an independent duty.  Sheen v. Wells Fargo, 38 Cal. App. 5th 346 (2019).  In so doing, the Court of Appeal explicitly noted that “[t]he issue of whether a tort duty exists for mortgage modification has divided California courts for years” and that “[t]he California Supreme Court has yet to resolve this division.”  Id. at 348.  Picking up the thrown-down gauntlet, the California Supreme Court granted review.

Like the Court of Appeal, the California Supreme Court used economic loss rule as its primary rationale, which provides that a party to a contract cannot recover in tort for purely economic damages—“i.e., pecuniary losses unaccompanied by property damage or personal injury” (Slip Op. at 2.)—unless the plaintiff can show a breach of a duty arising independent of the contract between the parties.  Robinson Helicopter v. Dana Corp., 34 Cal. 4th 979, 992-93 (2004).  The court relied heavily on this principle in deciding not to impose a duty on lenders, noting the underlying rationale of the rule is to “‘prevent the erosion of contract doctrines by the use of tort law to work around them.’”  (Slip. Op. at 15 (quoting Restatement, §3 at p. 2).)  The court reasoned that loan modification is just a renegotiation of an existing contract, wherein the lender is attempting to find a way to best enforce and protect the rights established by the original contract. (Id. at 17-18, 23.)

After noting that its approach was consistent with the majority of other jurisdictions (id. at 19-22), the court dispensed with plaintiff’s legal counterarguments.  In particular, the court noted that the economic loss rule is not limited to loan origination, but also modification because of its relation to the original contract between the parties.  (Id. at 23.)  The court also stated that the oft-cited factors from Biakanja v. Irving, 49 Cal.2d 647 (1958)—used to impose a duty of care in certain situations—do not apply when the parties are in contractual privity.  (Id. at 37.)

Lastly, and perhaps most importantly, the court rejected plaintiff’s policy arguments.  The court did recognize the underlying merit in plaintiff’s contention that the bargaining power in loan modification negotiations are lopsided in favor of lenders and servicers (who may have incentives to promote foreclosure and discourage modification), but ultimately stated that it was the role of the Legislature to strike the balance between those competing costs and benefits.  (Id. at 46-55.)  The court was not shy about prodding the Legislature to act to address the concerns raised by plaintiff about home loan modification negotiations, stating that “should it choose to the Legislature can both prescribe whether a lender must act ‘reasonably’ and (in some detail, if it chooses) what constitutes ‘reasonable’ behavior within this sphere.”  (Id. at 55.)  Justice Liu, in his concurring opinion, was more pointed: “[W]hether the mortgage market and affected communities would benefit from manipulative practices and ‘bargaining or information asymmetries’ . . . continues to be ripe for legislative consideration.”  (Id. at 11 (Liu, J., concurring).)  This open signaling from the California Supreme Court could spur the Legislature to act to address the concerns raised by both plaintiff and the court.

The court also seemingly overruled contrary precedent in a sweeping footnote (id. at 55 n.12), but did not delve into the details of the prior cases from the Court of Appeal that did find duties of care applicable to lenders.  One of the handful of cases that did find a duty of care and was heavily relied upon by plaintiffs—Alvarez v. BAC Home Loans Servicing, L.P., 228 Cal. App. 4th 941 (2014)—was addressed in Justice Jenkins’ concurring opinion, wherein he fell on his sword and addressed his participation in that case’s opinion.  In short, Justice Jenkins seemed to admit that he, along with the rest of the majority in Alvarez, misapplied the Biakanja factors and overlooked the fact that that analysis only applies where the parties are not in contractual privity.  (Id. at 2 (Jenkins, J., concurring).)

In granting review and deciding against the existence of a duty, the California Supreme Court has spoken clearly about the lack of a lender’s duty to process, review, and respond to loan modification—avoiding a potential instantaneous sea change in the allocation of risk and liability between lenders and borrowers.  However, at the same time, the Court has also, in asserting its inability to make law on the subject from the bench, laid the groundwork for potential Legislative action.  Finally, although the court seemingly has spoken with an intent to close the book on this issue in the judicial sphere, given the passing remarks made by the concurring Justices pointing out the items not conclusively addressed by the majority opinion (id. at 3-5 (Liu, J. concurring); id. at 2-3 (Jenkins, J., concurring)), lender litigants can reasonably expect that borrower plaintiffs will continue to jam their proverbial feet in the door.