A recent California Supreme Court ruling resolves an issue which has divided the lower appellate divisions and federal district courts in California for almost a decade. On March 7, 2022, in Sheen v. Wells Fargo Bank, N.A., 12 Cal. 5th 905, 2022 WL 664722 (Cal. 2022), the California Supreme Court expressly disapproved four lower appellate court decisions to the contrary and held that, when a borrower requests a loan modification, a lender owes no tort duty under general negligence principles to “process, review and respond carefully and completely to” the borrower’s application.
In Sheen, the borrower, under a second deed of trust, sued Wells Fargo Bank, N.A. (“Wells Fargo”) for negligence. Several years after purchasing his home (which purchase was secured by a first trust deed), the borrower used the home as collateral for two junior loans he took from Wells Fargo secured by second and third trust deeds. The borrower later suffered financial setbacks and missed payments on these junior loans. He submitted applications to Wells Fargo to modify the loans, but Wells Fargo did not respond. Instead, it sent letters informing him of the actions it might take because of the delinquency of his accounts. The letters did not specifically mention foreclosure. The borrower alleged that, because Wells Fargo did not provide him with a written determination regarding his eligibility for modification of the loans prior to sending him the letters, he believed the letters meant the loans had been modified such that they had become unsecured loans and his house could never be sold at a foreclosure auction, even if said loans were in default. Eventually, Wells Fargo sold the borrower’s second trust deed loan. In 2014, four years later, the new owner of the second trust deed loan foreclosed, and the borrower sued Wells Fargo.
Specifically, the borrower asserted a negligence claim against Wells Fargo, alleging that the bank owed the borrower a duty of care to process, review and respond carefully and completely to the loan modification applications he submitted. The borrower alleged that Wells Fargo breached this duty, causing him to “forgo alternatives to foreclosure,” and hence Wells Fargo should be liable for monetary damages relating to the loss, including the value of the home, the hotel and storage costs he incurred when he had to vacate the property, and the damage to his credit rating. Wells Fargo filed a demurrer in the trial court, arguing that it owed the borrower no such duty. The court of appeal affirmed the trial court’s decision to sustain the demurrer, concluding that the relevant authorities “decisively weigh against extending tort duties into mortgage modification negotiations,” but noted “the issue of whether a tort duty exists for mortgage modification has divided California courts for years.” The borrower appealed to the Supreme Court.
No Duty Pursuant to Statute
Initially, the Supreme Court (“Court”) noted that the borrower failed to identify any statute or regulation that required Wells Fargo to treat his loan modification applications with due care. California’s Homeowner Bill of Rights (“HOBR”) and federal law apply only to first lien mortgage modifications, and California’s general negligence statute, Civil Code § 1714, does not impose a general duty to avoid purely economic losses.
No Duty Under Common Law: The Economic Loss Rule
Next, the Court found that because the borrower’s claim arose from, and was not independent of, the mortgage contract, it was barred by the “economic loss rule” which provides that there is no recovery in tort for negligently inflicted “purely economic losses,” meaning financial harm unaccompanied by physical or property damage.
“Plaintiff and Wells Fargo did not agree that should plaintiff default and attempt to renegotiate his loan by submitting a modification application, Wells Fargo would “process, review and respond carefully and completely to the … applications Plaintiff submitted,” and could foreclose only after discharging such obligations. Sheen, 2022 WL 664722 at *7. To impose a tort duty in such circumstances would go further than creating obligations unnegotiated or agreed to by the parties; it would dictate terms that are contrary to the parties’ allocation of rights and responsibilities. The proposed duty would impede Wells Fargo’s right to foreclose by permitting foreclosure only after Wells Fargo discharges a tort duty to “process, review and respond carefully and completely to [a borrower’s] loan modification application[s].”
The Court further noted that California generally follows the judicially created economic loss rule within the lender-borrower context citing the “well-established principle of state law” from Nymark v. Heart Fed. Savings & Loan Assn. (1991) 231 Cal.App.3d 1089, 1096, 283 Cal.Rptr. 53: “A financial institution owes no duty of care to a borrower when the institution’s involvement in the loan transaction does not exceed the scope of its conventional role as a mere lender of money.” Moreover, citing cases from other jurisdictions, the Court noted that the application of the economic loss rule was consistent with well-reasoned decisions from other federal and state courts, including the views of other state supreme courts that have addressed the issue.
The Court further concluded no duty could be imposed through the use of the factors articulated in the Biakanja v. Irving case. See Biakania v. Irving, 49 Cal. 2d 647, 650 (Cal. 1958). Biakanja makes clear that its multifactor test finds application only when the plaintiff is a “third person not in privity” with the defendant. “Biakanja does not apply when the plaintiff and defendant are in contractual privity for purposes of the suit at hand.”
Finally, the Court distinguished the borrower’s claim from those in which tort recovery has been allowed despite the existence of a contract between the parties such as “insurance contracts” and “professional services contracts.”
Deferring to the expertise of the legislature, “In sum, the Legislature is better situated than we are to tackle the “significant policy judgments affecting social policies and commercial relationships implicated in this case,” the Court expressly declined the borrower’s invitation to
become the first state high court to create a judicial rule imposing a duty on lenders to exercise due care in processing, reviewing and responding to loan modification applications.
Sheen is not a panacea for all loan modification application claims. The Court expressly acknowledged and left the door open for possible causes of action against servicers for negligent misrepresentation and promissory estoppel in the loan modification context. However, the decision may assist to reduce defense litigation costs for servicers of California loans where borrowers attempt to rely solely on a theory of general negligence when they are unable to plead or prove statutory violations of the HOBR or federal law.