In a case that attracted a number of amici for both the borrower and the mortgagee, the U.S. Court of Appeals for the Fourth Circuit recently affirmed a trial court’s summary judgment ruling against a borrower holding that “the amount of a mortgage loan, by itself, cannot show substantive unconscionability under West Virginia law.”
However, the Fourth Circuit allowed the borrower’s claim of “unconscionable inducement,” holding that the applicable West Virginia statute authorized such a claim “even when the substantive terms of a contract are not themselves unfair.”
A copy of opinion in McFarland v. Wells Fargo Bank, N.A. is available at: Link to Opinion.
The plaintiff borrower purchased his home in West Virginia in 2004 for approximately $110,000. Two years later, he refinanced his home to consolidate and pay down other debt at the height of the housing boom in 2006. When the housing market collapsed, he found himself with a mortgage payment he couldn’t afford and facing foreclosure.
The borrower entered into a loan modification in May 2010, which reduced the interest rate and extended the term of the loan, but increased the principal amount. The borrower failed to make payments as promised and the mortgagee filed a foreclosure action in 2012.
In response to the foreclosure action, the borrower filed suit in federal district court, alleging that the mortgage was an “unconscionable contract” under the West Virginia Consumer Credit and Protection Act (WVCCPA) because the principal amount due on the loan far exceeded the home’s value.
The district court disagreed and granted the mortgagee’s motion for summary judgment, ruling that the fact that the loan exceeded the home’s value did not, standing alone, constitute “substantive unconscionability” under West Virginia law. The borrower appealed.
On appeal, the Fourth Circuit agreed “with the district court that the amount of a mortgage loan, by itself, cannot show substantive unconscionability under West Virginia law, and that [borrower] has not otherwise made that showing.”
However the Appellate Court noted that the trial court granted summary judgment in favor of the mortgagee “without considering the fairness of the process by which the agreement was reached.” The Fourth Circuit held that the WVCCPA “allows for claims of ‘unconscionable inducement’ even when the substantive terms of a contract are not themselves unfair.”
The Court first addressed the borrower’s argument that the district court erred as a matter of law when it ruled that the mortgage was not substantively unconscionable. The borrower argued that the loan was substantively unconscionable for two reasons: first, the loan far exceeded the value of the property; and second, “the loan did not provide a net tangible benefit” to the borrower.
The Fourth Circuit noted that under West Virginia case law, “[a] contract term is substantively unconscionable only if it is both ‘one-sided’ and ‘overly harsh’ as to the disadvantaged party. … The point is not to disturb the ‘reasonable allocation of risks or reasonable advantage because of superior bargaining power.”
The Appellate Court agreed with the district court “that under this standard, a mortgage agreement would not be deemed substantively unconscionable solely because it provides a borrower with more money than his home is worth. Whatever the pitfalls, receiving too much money from a bank is not what is generally meant by ‘overly harsh’ treatment, and we have no reason to think that the West Virginia Supreme Court of Appeals would apply its standard in such a counterintuitive manner.”
The Fourth Circuit rejected the argument of the borrower and several amici curiae consumer advocacy groups that the harm to borrowers and the general public caused by loans that exceed home values made such loans substantively unconscionable because the widespread practice of overvaluing homes contributed to a national foreclosure crisis, and “[w]hen a borrower is bound to a mortgage that exceeds the value of his home, he is trapped, unable to refinance to obtain better terms or sell his home to relocate, and foreclosure is the result.”
The Court reasoned that, while consumers “may be harmed, sometimes grievously, when they take on more mortgage debt than their homes are worth” and it had “no reason to doubt that West Virginia’s courts would acknowledge that disproportionate debt may be dangerous both for homeowners and for the broader economy,” “[t]he fact that a practice is harmful does not by itself make it substantively unconscionable as a matter of West Virginia contract law. Rather, … substantive unconscionability is an equitable doctrine reserved for those cases in which a contract is ‘so one-sided that it has an overly harsh effect on the disadvantaged party.’ … And an under-collateralized loan, though it ultimately may cause harm, cannot meet this standard, because it will benefit the borrower in at least some respects and operate to the detriment of the lender in others.”
The Fourth Circuit believed its conclusion that loan balance, by itself, was not evidence of substantive unconscionability was supported by the practical “problems that would arise in fashioning a remedy in such circumstances.” For example, if a particular contract term is found to be unconscionable, a court may sever the offending term, but the only way of avoiding the harm of being loaned too much money would be to void the entire agreement. The Court noted that, although this would spare the borrower foreclosure, it would also require him to return the loan principal to the lender, which is precisely what he wants to avoid.
Because the West Virginia Supreme Court of Appeals “has been clear that ‘cancellation of the debt’ … ‘is not a permissible remedy’ under circumstances like those in the case at bar, the Fourth Circuit refused to “create a new variant of substantive unconscionability for which there appears to be no sensible remedy.”
The Fourth Circuit also rejected the borrower’s alternative theory that the mortgage was substantively unconscionable because it did not provide him with any “net tangible benefit,” agreeing with the district court that this inquiry was irrelevant to the legal standard of substantive unconscionability under West Virginia contract law.
The Court reasoned that the borrower “appears to have borrowed the ‘net tangible benefit’ test … from West Virginia’s anti-predatory lending statute, which prohibits mortgage brokers from charging certain fees ‘unless the new loan has a reasonable, tangible net benefit to the borrower considering all of the circumstances.” However, the Fourth Circuit pointed out, the borrower did not allege the lender had violated this law nor cited any West Virginia case law applying this language in the context of a statutory “unconscionable contract” claim.
The Fourth Circuit held that the test of unconscionability under West Virginia law focuses on whether a contract is so “one-sided” and “overly harsh” that it should not be enforced as written. In the Court’s words, “[w]hether a contract provides either or both parties with a ‘tangible net benefit’ is an entirely separate question; contracts are made all the time that include terms that might not provide either party with a ‘net tangible benefit’ yet remain fair and even-handed — or at least fair and even-handed enough not to be considered substantively unconscionable under West Virginia’s standard.”
The Court then addressed the borrower’s argument that “the district court erred by dismissing his unconscionable contract claim solely on the ground that he could not show substantive unconscionability.” Specifically, the borrower argued that his unconscionability claim could not be dismissed without considering “the fairness of the process leading up to contract formation.”
The Fourth Circuit agreed, in part, finding that although “West Virginia law clearly requires a showing of substantive unconscionability to make out a traditional claim that a contract itself is unconscionable … we think it is equally plain that the WVCCPA authorizes a stand-alone unconscionable inducement claim which, unlike its common-law antecedents, may be based entirely on evidence going to process and requires no showing of substantive unfairness.”
The Court’s conclusion was based primarily on the statutory text itself, which expressly “authorizes a court to refuse enforcement of an agreement on one of two distinct findings: that the agreement was ‘unconscionable at the time it was made, or [that it was] induced by unconscionable conduct.”
Accordingly, the Fourth Circuit held “that the district court erred in dismissing [borrower’s] claim of unconscionable inducement on the ground that substantive unconscionability is a necessary predicate of a finding of unconscionability under the WVCCPA.”
The case was remanded to the district court with instructions to “consider in the first instance whether [borrower’s] mortgage agreement was induced by unconscionable conduct.”