I. What Is Mortgage Rescission?
Rescission is a way for a borrower to get out of a mortgage that was fraudulently or deceptively originated. For example, if the lender misrepresented the terms of the mortgage by failing to disclose a balloon payment, or the nature of the adjustable rate, or advised the borrower to inflate income to qualify for a larger loan – gasp! does this sort of thing ever happen? up until recently, all the time – the borrower may cancel the loan.
II. The Legal Foundation For Mortgage Rescission
The main statutory vehicle for rescission is the Truth in Lending Act (“TILA”), 15 § U.S.C. 1601 et seq., and its regulatory partner, Regulation Z, 12 C.F.R. 226.31, et seq.. TILA and Regulation Z are complicated, so it is easy for a creditor to violate them. The most common violations involve inadequate disclosures. See 15 U.S.C. §§ 1638(a)-(b)(1) for some of the required disclosures. Regulation Z has its own plethora of required disclosures.
III. Rescission Of Non-purchase Money Loans
For a non-purchase money loan such as a refinancing or a HELOC, the lender must also provide notice – two copies to each borrower (thus, if the borrower has a multiple personality disorder with more than two personalities, then some of the personalities will have to share) – that the borrower may void or “rescind” the loan within three business days of the transaction. However, the right to rescind can be extended well beyond three days if the lender fails to give adequate disclosure. The relevant language from Regulation Z states:
When the creditor has failed to take the action necessary to start the three-day rescission period running, the right to rescind automatically lapses on the occurrence of the earliest of the following three events:
• The expiration of three years after the occurrence giving rise to the right of rescission.
• Transfer of all the consumer’s interest in the property.
• Sale of the consumer’s interest in the property, including a transaction in which the consumer sells the dwelling and takes back a purchase money note and mortgage or retains legal title through a device such as an installment sale contract.
Thus, the borrower could have three years to rescind the mortgage contract!
IV. From Secured To Unsecured Status
Rescission of the mortgage voids the lender’s security interest in the property, and converts the debt to unsecured status. The lender is required to return the interest portion of the mortgage payments it received, and the borrower must return the amount borrowed, minus principal already paid. The borrower may, of course, need to take out a new loan to get the money to repay the principal, but if the rescinded loan’s terms were onerous, the borrower may be able to get a loan with better terms. Since the early loan payments are mostly interest, this means that the borrower could effectively enjoy a three-year interest-free loan.
Outside of bankruptcy the rescinding borrower has to pay back the money received from the lender. In bankruptcy the debtor can rescind the mortgage, thus rendering the debt unsecured, and then modify or discharge the debt as part of the bankruptcy.
As you might expect, rescission is not self-executing (the Lord High Executioner in Gilbert & Sullivan’s operetta, The Mikado, would undoubtedly sympathize) and requires court intervention. Therefore, to successfully rescind a mortgage and treat it as an unsecured debt in bankruptcy, the debtor must convince the judge that TILA and Regulation Z really were violated by the lender.
V. Rescission In Chapter 7
The successful Chapter 7 debtor could in theory rescind a mortgage, thus converting it to unsecured status, and discharge it in a Chapter 7 bankruptcy – in essence, getting a free house out of the process. However, in practice this is rare. Indeed, in Yamamoto v. Bank of New York, 329 F. 3d 1167 (9th Cir. 2003) the Ninth Circuit held that a court – bankruptcy or district – had discretion to condition rescission on the return of the principal. And if the TILA action is unsuccessful, the lender may file a lawsuit to recover costs and attorney’s fees, alleging that the TILA action was frivolous. It is worth noting that while a court can condition rescission on return of principal, it is not required to. See, e.g., Botelho v. US Bank, N.A., 692 F. Supp. 2d 1174 (N.D. Cal. 2010).
Of course, in the highly unlikely event that the debt is discharged in its entirety and the debtor gets a “free house”, the nonexempt equity would be liquidated by the Chapter 7 Trustee for the benefit of creditors. Sorry – no free lunches here.
VI. Rescission In Chapter 13
How does this play out in Chapter 13? In theory the debtor could rescind, and deal with the now unsecured debt through the Chapter 13 plan; perhaps paying a relatively small percentage of the debt over the life of the plan, and discharging the remaining balance upon receiving a Chapter 13 discharge. Unfortunately, in practice things are not quite so easy. Two obvious problems conspire to make rescission a potentially weak Chapter 13 tool.
A. The Sudden Surge In Nonexempt Equity
First, after the rescission the debtor may suddenly have a great deal of nonexempt equity in the property. This can create a problem due to the Chapter 7 liquidation test for Chapter 13. This Chapter 13 plan requirement, which is found in 11 U.S.C. § 1325(a)(4), specifies that the plan must repay the general unsecured creditors at least the amount they would have gotten if the nonexempt assets had been liquidated in a Chapter 7 bankruptcy. Therefore, mortgage rescission could end up forcing the debtor to make impossibly large plan payments.
B. Too Much Unsecured Debt For Chapter 13
Second, since rescission converts the previously secured debt to unsecured status, the debtor’s unsecured debts may exceed the Chapter 13 unsecured debt limit of $360,475 found in 11 U.S.C. § 109(e), thus rendering the debtor ineligible for Chapter 13 relief.
C. Rescission: The Lien Strip Alternative
In spite of the negatives just mentioned, rescission may provide a way to strip off a second mortgage, even if it isn’t wholly unsecured – i.e., when a Lam motion (discussed in my last post) can’t be done. In other words, if rescission is available it can provide a way around the bifurcation prohibition of Nobelman v. American Savings Bank, 508 U.S. 324 (1993) discussed in my previous post.
Thus, if the debtor is underwater, but not sufficiently to strip off a HELOC through a Lam motion – i.e., there is some house behind the HELOC – the debtor may still be able to use rescission to strip off the second if the lender violated TILA and Regulation Z.
There are forensic experts who, for a fee, will review your client’s mortgage to determine whether a TILA lien strip is possible. However, their services are not free, so impecunious clients may be reluctant to pay for them in the absence of a guarantee of success – which an attorney obviously cannot give.