An opinion by Bankruptcy Judge Christopher M. Klein of Sacramento, Calif., is a hoot. It deserves reading in full text just for the entertainment value. If practices he describes are prevalent in the auto finance industry, subprime auto lending is headed for a bust like what happened in the home mortgage business 10 years ago.
On a technical level, Judge Klein’s December 18 opinion explains why a flagrantly false loan application will not result in nondischargeability if the lender was complicit in fabricating the credit submission.
Minimal Income and a Large Loan
The debtor owned a car for 17 months and had paid the loan on time every month. She was angling to buy a newer model used car that would cost about $35,000. She was trading in her older car worth $20,000 but still owed about $26,500 on the note. The dealer agreed to locate $46,000 in financing to subsume the cost of the newer car and the shortfall on the trade-in, plus associated taxes and fees.
The dealer proposed a loan calling for monthly payments of $650 for 60 months plus a balloon payment of almost $12,000 on maturity. The balloon was necessary because the debtor’s income would not justify a monthly payment above $650.
The dealer filled out and printed the loan application on a computer. The debtor initialed a line showing she was employed with monthly income of $2,200. In pen, someone added monthly Social Security income of $1,400, raising her total monthly income to $3,600, which is suspicious in itself because the debtor was age 54. The debtor had not initialed the Social Security line.
The loan application showed the debtor was paying monthly rent of $200. The identity of the landlord was not disclosed, and no one verified the rent. As Judge Klein said later in his opinion, rent that low in the San Francisco area is “improbable.”
There were more red flags. The loan application listed no assets, no bank accounts and no debts other than the loan on the car being traded in.
Judge Klein said that the loan would have been rejected automatically if the debtor had less than $3,600 in income or more than $200 in rent.
An auto finance company affiliated with the manufacturer purchased the loan without recourse, and the debtor purchased the car. The lender had obtained a credit report on the debtor.
The credit report showed $2,200 in income, no Social Security income, and a loan on a different car. Among other discrepancies compared to the loan application, the credit report showed two accounts in collection and six other accounts with monthly payments in excess of $1,100.
After purchase, the debtor paid the note for two months, then the car was totaled in an accident. The debtor made no further payments. The lender said that the debtor’s insurance company denied coverage but did not explain why the lender had not sued the insurer.
The debtor filed a chapter 7 petition two years after purchasing the car. In the petition, she listed her income as $2,200 and said her monthly rent was $1,050. Based on discrepancies in income and expenses between the loan application and the schedules, the lender filed an adversary proceeding seeking a judgment for the $46,000 and a declaration of nondischargeability for a false financial statement under Section 523(a)(2)(B).
In the loan application, the debtor had overstated her income and understated her expenses. Open-and-shut nondischargeability, right?
The Lender Loses Despite the Debtor’s Default
The debtor did not answer the dischargeability complaint. Default was entered, and the lender sought a default judgment for the amount of the debt and for nondischargeability.
Conducting an independent review under F.R.C.P. 55(b)(2), Judge Klein ultimately held a trial with witnesses and evidence from the lender. He said that the “court need not uncritically accept a plaintiff’s version of the facts.”
Without corroborating evidence, the lender alleged at trial that the debtor was a stray buyer for her boyfriend, who was driving the old and new cars and had been paying the notes on both.
Judge Klein explained that Section 523(a)(2)(B) requires a “materially false” financial statement and “reasonable” reliance by the lender. “Justifiable” reliance is not sufficient under Section 523(a)(2)(B), he said, because lenders could insulate loans from discharge by encouraging borrowers to falsify loan applications.
Judge Klein concluded there was “a failure of proof, even under the lenient standards of default judgments.” He entered judgment for the debtor, ruling that the lender had not relied on the financial statement and that reliance would not have been reasonable.
Judge Klein determined that the “case smacks of a creditor strategy to obtain financial statements that are designed more for the purpose of snaring the borrower than for making a responsible business decision.” He added that the loan application was tailored “to satisfy [the lender’s] financial ratios.”
In other words, he found that “the credit application was treated as a mere formality upon which there was not actual reliance and belies the debtor’s intent to deceive.”
Judge Klein said that “no sentient lender could have construed the credit report as supporting the accuracy of the credit application.” Similarly, he said that “no sentient banker” would have believed that a borrower with even $3,600 in monthly income could cover a balloon payment of almost $12,000.
The lender contended that the discrepancies did not matter because it relied entirely on the debt-to-income ratio in the loan application.
Judge Klein was incredulous. He concluded that the lender did not rely on the credit application. Instead, he found that the lender had relied on the debtor’s history of having made payments for 17 months on the old car. He went on to say it was not “reasonable” to rely on the loan application “without at least making a searching inquiry.”
The lender told Judge Klein that it was eager to appeal. So, he denied the motion for a default judgment and dismissed the adversary proceeding with prejudice.
Judge Klein does not suffer abusive lenders. In March 2017, he imposed more than $46 million in compensatory and punitive damages on a bank for foreclosing and evicting a couple from their home although the lender knew they had filed a chapter 13 petition expressly to halt foreclosure. The judgment included $40 million in punitive damages for what Judge Klein called a “Kafkaesque nightmare of stay-violating foreclosure.” Sundquist v. Bank of America NA, 566 B.R. 563, 571 (Bankr. E.D. Cal. March 23, 2017).
Later, the parties reached a confidential settlement requiring Judge Klein to expunge his opinion excoriating the lender. Ultimately, he approved the settlement but did not vacate his opinion. Sundquist v. Bank of America N.A. (In re Sundquist), 580 B.R. 536 (Bankr. E.D. Cal. Jan. 18, 2018).
An opinion by Bankruptcy Judge Christopher M. Klein of Sacramento, Calif., is a hoot. It deserves reading in full text just for the entertainment value. If practices he describes are prevalent in the auto finance industry, subprime auto lending is headed for a bust like what happened in the home mortgage business 10 years ago.
On a technical level, Judge Klein’s December 18 opinion explains why a flagrantly false loan application will not result in nondischargeability if the lender was complicit in fabricating the credit submission.
Minimal Income and a Large Loan
The debtor owned a car for 17 months and had paid the loan on time every month. She was angling to buy a newer model used car that would cost about $35,000. She was trading in her older car worth $20,000 but still owed about $26,500 on the note. The dealer agreed to locate $46,000 in financing to subsume the cost of the newer car and the shortfall on the trade-in, plus associated taxes and fees.
The dealer proposed a loan calling for monthly payments of $650 for 60 months plus a balloon payment of almost $12,000 on maturity. The balloon was necessary because the debtor’s income would not justify a monthly payment above $650.
The dealer filled out and printed the loan application on a computer. The debtor initialed a line showing she was employed with monthly income of $2,200. In pen, someone added monthly Social Security income of $1,400, raising her total monthly income to $3,600, which is suspicious in itself because the debtor was age 54. The debtor had not initialed the Social Security line.
The loan application showed the debtor was paying monthly rent of $200. The identity of the landlord was not disclosed, and no one verified the rent. As Judge Klein said later in his opinion, rent that low in the San Francisco area is “improbable.”