LENDER LIABILITY REVISITED
From Washington
Kathleen W. Collins

Kathleen W. Collins is a partner in Morgan, Lewis & Bockius, and Washington Counsel of the Bank Insurance & Securities Association. She and Richard Starr write the "From Washington" column in alternate issues.

WHEN The New York Times offers its editorial view that "lenders should also be held to suitability standards, akin to the rules for stock brokers," it's time for bankers to be afraid—very afraid.

Lawyers like to say that bad facts make bad law. Applying that basic truism to today's subprime lending situation, it's no wonder that Congress and bank regulators are in the latest race to make sure "THAT never happens again." With interest rates on $660 billion in loans with adjustable rate mortgages (ARMs) set to increase before year's-end, credit standards being raised while home values flatten, and foreclosures in several areas at all-time highs, the bad facts are about to get worse. Lenders will be told to take their medicine, and that prescription may include suitability standards.

Recalling the 1980s

Any banker who lived through the early days of the lender liability lawsuits in the mid-1980s will no doubt recoil in horror at the thought of loan suitability standards. The fundamental theory of the initial suits, many of which emanated from California, was that the bank held a fiduciary relationship to its borrower, which was typically a commercial entity that had fallen on hard times and was having difficulty repaying its loan.

A fiduciary owes a special duty to a borrower, the theory went, and must look out for the borrower's interest with special care, even at cost to the bank. The borrowers prevailed in a few early suits, but these results were usually reversed at the appellate level.

As a bank general counsel at the time, I can recall receiving my first letter threatening a lender liability suit (or counterclaim if the bank filed suit to collect on its loan) on the basis that the bank had failed in its role as a lender because: 1) It had lent the borrower too much money originally, 2) when the borrower wanted an increase in its line of credit, the bank had refused; and 3) now the bank had the audacity to want its money back. The bank's new, first ever fax machine went into overdrive as the borrower's attorneys heaped accusations of bad faith (and worse) on the lending officers. Who knew?

When The New York Times offers its editorial view that 'lenders should also be held to suitability standards, akin to the rules for stock brokers,' it's time for bankers to be afraid.

While the courts largely rejected this type of 'lender as fiduciary' argument, case law ultimately produced different results when the facts demonstrated that a special relationship between the bank and the borrower had been established—for example, when a lender held itself out as financial advisor to the borrower. Which brings us to the apparent regulatory and/or legislative fix to the subprime lending mess, and how it has the potential to fundamentally affect the way banks deliver services and products, including securities and insurance.

Dealing with 'payment shock'

On July 10, 2007, the federal financial regulatory agencies issued a "Statement on Subprime Mortgage Lending," in an effort to address ARM products and the 'payment shock' that can result from the re-pricing that is occurring in a difficult market. Much of the guidance is well done, particularly the encouragement to lenders to work constructively with residential borrowers who are in default, or whose default is reasonably foreseeable.

But when it comes to establishing 'consumer protection principles,' the guidance includes the requirement that banks "provide information that enables consumers to understand material terms, costs and risks of loan products at a time that will help the consumer select a product." Sounds an awful lot like providing financial advice, doesn't it?

And what if the consumer would be better served by not borrowing the money at all? What if borrowing money to invest in an annuity, or borrowing money to pay a life insurance premium isn't the smartest thing the customer should be doing right then, when the stock market is performing well? Should the loan officer be expected to be schooled in the risks and rewards of advising borrowers who want to purchase products and services the loan officer was not hired (or licensed) to sell in the first place?

Best of luck

And how are our legislators poised to deal with the 'bad facts' of subprime lending? No bills directly addressing the situation have been introduced as of this writing, although even a description of the possible legislation has morphed from subprime lending into "predatory lending legislation" in the popular press, despite bankers' legitimate efforts not to confuse the two terms. Good luck on that one.

ReEcent guidance includes the requirement that banks 'provide information that enables consumers to understand material terms, costs, and risks of loan products at a time that will help the consumer select a product.'

MEANWHILE, IF THIS IS THE DIRECTION IN WHICH REGULATORS AND CONGRESS WISH TO STEER THE BANKING INDUSTRY, ALL PARTIES INVOLVED SHOULD RECOGNIZE THE RAMIFICATIONS IN ADVANCE—SPECIFICALLY, THE TRAINING AND OTHER COSTS, AND THE TIME IT WILL TAKE FOR THE INDUSTRY TO ADAPT TO A VERY NEW ROLE.