United States: California Supreme Court Weighs In On Negligence Claims Related To Mortgage Loan Modifications

On March 7, the California Supreme Court settled the issue of whether a mortgage servicer owes a duty of care to a borrower in the context of loan modification review, holding that negligence claims related to loan modification were barred by the economic loss doctrine and that there is no special relationship between a lender and borrower that would give rise to a duty. 

In California, the general rule has historically been that 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."¹ For several years, courts interpreted that rule to include loan modification review activities, as those were within the scope of a typical lender-borrower relationship.

In 2013, the First Appellate District cast doubt on the application of the Nymark rule in the context of a residential construction loan transaction.² While acknowledging that Nymark has been the general rule and that Plaintiff had not alleged any special relationship or fiduciary duty, the court applied a six-factor test first articulated in Biakanja v. Irving.³ Applying the Biakanja factors⁴, the court held that the lender had breached its duty by failing to review the plaintiff for a loan modification in good faith. In 2014, the First Appellate District again reaffirmed its position in finding that a lender owed a duty of care when reviewing a borrower for loan modification.

Meanwhile, the Second Appellate District reached the opposite conclusion that same year.⁵ In Lueras, the court specifically rejected Jolley and held that "a loan modification is a renegotiation of loan terms, which falls squarely within the scope of the lending institution's conventional role as a lender of money."⁶ In reaching that conclusion, the court analyzed the extensive line of authority that had applied the Nymark rule and Biakanja factors and found that no duty existed.

The California Supreme Court's recent decision in Sheen v. Wells Fargo Bank, N.A. now settles that conflict.⁷ In Sheen, the Court held that the Biakanja factors did not "provide a compelling basis to recognize such a duty."⁸ Instead, the Court held that the relationship between a lender and borrower is governed by the contracts between them—the note and deed of trust—and therefore, a negligence claim would be barred by the economic loss doctrine. Id. The Court stated that "there is good reason to adhere to the economic loss rule in this case, given the nature of the parties' contractual relationship and how that relationship might be disrupted by recognition of the duty plaintiff advances"- the duty to "process, review and respond carefully and completely to [a borrower's] loan modification application." Id. 
    
While the Court's ruling settles the issue of whether a lender owes a borrower a duty of care in the loan modification context, the Court specifically declined to rule on the borrower's related claims for negligent misrepresentation and promissory estoppel. While we will likely see a decline in negligence claims in the loan modification context, lenders and financial institutions should anticipate that borrowers will continue to allege other claims against them in that context.