by State law precluded a creditor’s claim of nondischargeability due to fraud in the case of Heritage Pac. Fin. v. Montano (In re Montano), __ B.R. __, 2013 W.L.5890681 (B.A.P. 9th Nov. 1, 2013). There, the debtor, Montano, an El Salvadorian with limited English language skills and no ability to read or write in English, contacted a mortgage broker seeking to obtain financing to purchase a home. The broker took Montano’s information over the phone and used it to create a Universal Residential Loan Application (URLA). Montano claimed that, without his knowledge, the broker included a number of fraudulent statements and documents in the application. The broker obtained a primary loan for the debtor from WMC Mortgage Corp. (WMC) in the amount of $348,750 and a second loan from the same company in the amount of $89,990.
After making only five payments, Montano defaulted and WMC foreclosed and sold the property. The now-unsecured second loan was purchased by Heritage Pacific Financial, LLC. Montano filed a chapter 7 bankruptcy noting the $89,990.00 unsecured debt and Heritage filed an adversary proceeding seeking court determination that the loan was nondischargeable under section 523(a)(2)(A) and (B) based on the false documentation submitted in connection with the loan application. Though it was undisputed that the application documents contained falsehoods, Montano raised several defenses, including that the action was barred by California law. He sought attorney’s fees and costs.
The bankruptcy court granted the debtor’s motion for summary judgment but, stating that the case involved “close questions,” the court initially denied the debtor’s motion for attorney fees under section 523(d). On reconsideration of the 523(d) issue, however, the bankruptcy court concluded that there was a lack of evidence as to WMC’s reliance on the falsified loan documents. It awarded Montano attorney’s fees and costs in excess of $70,000.00.
On appeal, the BAP applied a de novo review to the bankruptcy court’s grant of summary judgment on the basis of state law, and an abuse of discretion standard to the award of fees and costs.
The structure of the California laws is such that under the one-action rule a lender is limited to foreclosure (CCCP section 726(a)) and a deficiency judgment is not permitted where the loan is purchase money loan and the debtor lives on the property (sections 726(b) and 580b), unless the loan is induced by the debtor’s fraud (section 726(f)). Under section 726(g), however, a creditor’s right to a deficiency judgment in the event of fraud does not apply where the loan was for the purpose of purchasing the property and was for less than $150,000.00.
The court rejected Heritage’s initial argument that the section 726(b)’s anti-deficiency rule does not apply to “sold out” junior lienholders. The court found that the plain language of the relevant statutes did not support Heritage’s view and that state courts had interpreted the law to apply to sold-out junior lienholders. See, e.g., Kurtz v. Calvo, 75 Cal. App. 4th 191, 194 (Cal. Ct. App. 1999). Cases cited by Heritage for the opposite conclusion were inapplicable as not involving loans used to purchase the property. Nor did the fact of the foreclosure cause the loan to lose its purchase money status. See DMC Inc. v. Downey Sav. & Loan Assn., 99 Cal. App. 4th 190, 196 (Cal. Ct. App. 2002).
The court also rejected Heritage’s argument that where the loan was induced by fraud, it could recover the deficiency despite the exception set forth in section 726(g) because the total loan was in excess of $150,000.00 and it was only after the junior lienholder was “sold out” by the senior lienholder that the amount owed was diminished to less than that amount. The court found that the plain language of the statute did not aggregate the loans used to purchase the property and despite several amendments to the statute, had not been changed to do so. It further found that any perceived unfairness in permitting a debtor to discharge a loan induced by fraud was a matter for the legislature rather than the judiciary.
With respect to the award of attorney fees and costs, the court found that the bankruptcy court did not abuse its discretion in reconsidering its initial decision or in ultimately granting the award. Under section 523(d) a debtor seeking attorney fees and costs must meet the initial burden of proving the threefold elements: 1) that the creditor sought to exempt from discharge, 2) a consumer debt, and, 3) that the debt was ultimately discharged. The bankruptcy court found, and the BAP agreed, that once Montano made his prima facie case, Heritage failed to maintain its burden of demonstrating that its prosecution of the case was “substantially justified.” See Heritage Pac. Fin. v. Machuca, 483 B.R. 726 (B.A.P. 9th Cir. 2012). Here, Heritage’s failure to demonstrate that WMC actually relied on the false financial statements, despite the bankruptcy court’s invitation to supplement the record with evidence on that subject, was fatal to its defense against the motion for fees and costs.