Shared Responsibility Mortgages

• Publication year: 2015
• Author: Harold Justman, Henry Chuang, and Julia M. Wei

Shared Responsibility Mortgages

Harold Justman, Henry Chuang, and Julia M. Wei

Harold Justman

Harold Justman has litigated real estate disputes for thirty-five years. Recently he has taken the position of Academic Consultant to the Real Estate Program and Adjunct Professor of Real Estate at Menlo College. He is also qualified as an expert witness regarding the standard of care of real estate brokers.

Henry Chuang

Henry Chuang has represented private money investors, foreclosure investors, mortgage brokers, loan servicers, and landlord and tenants at the Law Offices of Peter N. Brewer. Henry was the Chair of the Santa Clara County Bar Association Bankruptcy Section and has been a member of their Strategic Planning Committee, Board of Trustees, Finance Committee, and Judiciary Committee.

Julia M. Wei

Julia has represented private money investors, foreclosure investors, mortgage brokers, and loan servicers for over a decade with the Law Offices of Peter N. Brewer. She has jury trial experience and has litigated adversary proceedings in the bankruptcy courts. Julia can be reached at 650.327.2900 or julia@brewerfirm.com.

I. Introduction

A. The Great Recession and the Foreclosure Crisis

From 2006 to 2009, house prices in the United States fell by thirty percent.¹ The depressing shock that falling house prices had on consumer spending was amplified by a foreclosure crisis, referred to as the "Great Recession."²From 2007 to 2009, for every one percent of homeowners who went into foreclosure, house prices fell by 1.9 percentage points.³ There is a different form of mortgage called "shared responsibility mortgages" that could have prevented most of the foreclosures and possibly reduced the fall in housing prices by 9.7 percentage points.⁴ It would have saved $2.5 trillion in housing wealth.⁵

B. Shared Responsibility Mortgages

A shared responsibility mortgage ("SRM") is the most ambitious model for financial reform of the mortgage market.⁶ The advocates for SRMs boldly predict that SRMs will prevent a large-scale foreclosure crisis in the mortgage market by avoiding foreclosures entirely.⁷ The structure of a SRM is as follows: If the home price rises above the original purchase price, the lender receives five percent of the capital gain upon the sale or refinancing of the home;⁸ if the home price falls below the original purchase price, the principal of the mortgage is reduced,⁹ with the principal reduction determined by a house-price index monitored by the government;¹⁰ and if the homeowner cannot afford the reduced mortgage payments, the homeowner can sell the home and keep the equity which has been created by the principal reduction.¹¹ This article will address the primary issues raised by implementing a SRM system.

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II. The California Shared Appreciation Loan

To create a legally effective SRM, new laws would need to address the necessary details. Well-intended macroeconomic models do not make good policies without appropriate laws. California's Shared Appreciation Loan ("SAL") law provides a reference point for some of the legal details associated with an SRM. While other states, such as New York, have implemented similar rules, their statutes have not been as comprehensive. For example, New York's statute has primarily focused on disclosure requirements.¹²

California's SAL law was enacted in the early 1980s to address high home mortgage interest rates. When the SAL law was enacted, homebuyers were facing double-digit interest rates.¹³ Because falling home prices were not a problem, the SAL law only addressed the sharing of appreciation above the original purchase price. No downside risk protection for the homeowner was included in the SAL law. Also, much of the SAL law expired in 1987, although it continues to be available for seniors.¹⁴

III. Legal Issues Regarding SRMs

The California SAL law provides a useful checklist of the legal issues that should be addressed to effectively implement SRMs.

A. Lender and Borrower Relationship

When a lender makes a loan, it wants to limit its legal liability for contract damages. Contract damages are generally limited to encourage commercial transactions by enabling contracting parties to estimate the financial risks of their business activities.¹⁵ In contrast to tort damages, contract damages typically do not allow a recovery of emotional distress damages.¹⁶ Moreover, a core principle of contract law is the theory of efficient breach, which recognizes the right of a contracting party to intentionally breach a contract and pay contractual damages without incurring punitive damages.¹⁷

While California law has long held that a lender owes no duty of care arising from tort law to a borrower,¹⁸ this doctrine has been weakened by some courts during times of economic crisis.¹⁹ For example, the Great Recession prompted one court to seek to impose tort damages upon a lender. In the case of Lueras v. BAC Home Loans Servicing, the court broke from the long-standing doctrine that lenders do not have a duty of care to borrowers.²⁰ In the Lueras case, the lender had rescheduled a foreclosure sale four times, pending loan modification communications with the borrower.²¹ Then the lender allegedly told the borrower that the foreclosure would be reset again, but instead proceeded with the foreclosure.²²

The Court of Appeal acknowledged that a loan modification is a renegotiation of loan terms, which falls squarely within the scope of a lending institution's conventional role as a lender of money.²³ In such role, a lender owes no duty of care to a borrower.²⁴ Accordingly, absent a contractual obligation to do so, a lender has no common law duty to offer, consider, or approve a loan modification, or to offer alternatives to foreclosure to a borrower.²⁵ The Court of Appeal reaffirmed that due to the exhaustive nature of the non-judicial foreclosure statutes, the courts have refused to read any additional common law requirements into the non-judicial foreclosure process.²⁶ However, the Court of Appeal did hold that a lender owes a duty to a borrower to not make material misrepresentations about the status of a loan modification application, or about the date, time, or status of a foreclosure sale; such misrepresentations raise the possibility of tort damages.²⁷

Since an SRM places a lender in an unconventional role, the law should clearly address the relationship between a borrower and a lender in an SRM. California's SAL law states as follows: "The relationship of the borrower and the lender, as to a shared appreciation loan, is that of debtor and creditor and shall not be, or be construed to be, a joint venture, equity venture, partnership, or other relationship."²⁸ To more effectively reduce the risk to a lender in an SRM loan, a statutory provision expressly stating that the lender owes no duty of care to the borrower could be enacted.

B. Character of the Lender's Appreciation

Consistent with the borrower and lender relationship that is necessary to reduce the lender's risk of tort liability, a proper characterization of the lender's appreciation should identify the lender's portion of the appreciation as interest, as opposed to a carried interest. California's SAL law expressly identifies the lender's share of the appreciation as interest. It provides that "the borrower shall additionally be obligated to pay to the lender contingent deferred interest . . . ."²⁹ Then "contingent deferred interest" is defined in the statute as ". . . the lender's share of net appreciated value, calculated as the sum resulting upon multiplying the net appreciated value by a percentage agreed by the lender and borrower, not to exceed [fifty] percent."³⁰ This characterization of the lender's interest allows the lender to share in any increase in the home equity without taking on the risks of being a co-owner in the home.

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An issue related to characterizing the lender's share of the appreciation as interest is the usury law. The SAL law expressly addresses that issue: "A shared appreciation loan which at origination bears a fixed interest rate complying with the usury provisions of Article XV of the California Constitution shall not be deemed to become usurious by reason of the payment of contingent deferred interest pursuant to this chapter."³¹ This characterization of the interest for usury law purposes prevents the borrower, in the event of a significant rise in home prices, from claiming that the lender's share in the increased equity produces a yield on the SRM that exceeds the applicable limitation on interest rates under the usury law.

C. Character of Contingent Deferred Interest to Borrower

Characterizing the lender's share of appreciation as contingent deferred interest creates tax consequences for the borrower. The SAL law therefore contains an appropriate notice to the borrower: "Use of the shared appreciation loan will have income tax or estate planning consequences which will depend upon your own financial and tax situation. For further information, you are urged to consult your own accountant, attorney, or other financial advisor. The questions you should discuss include the tax deductibility of the contingent interest payment, your right to utilize that deduction in years other than the year it is paid, and the effect of the loss of tax benefits before that time."³²

This statutory notice is alluding to several tax problems associated with the tax deductibility of home mortgage interest. There are limits on the deductibility of home mortgage interest.³³ There are also limits on the deductibility of itemized deductions on Schedule A, where home mortgage interest is reported.³⁴ A large home mortgage deduction in one year may trigger an alternative minimum tax.³⁵ Of most concern to a borrower would be the risk that by deferring interest, the borrower may have to provide cash to close the escrow on a sale of the property. The SAL law provides the following notice to the borrower: "However, if you sell with...