Houses Divided: Does TILA Prohibit Classwide Rescission Claims by Subprime Borrowers?

Both Wall Street and Washington have been moving quickly in response to the tumult in subprime mortgage lending. Courts are also having their say, as borrowers facing foreclosure bring lawsuits that place the blame on lenders for allegedly failing to disclose the true loan terms. The potential exposure of subprime lenders turns on the outcome of ongoing litigation under the Truth-in-Lending Act (TILA), as judges decide whether disgruntled borrowers have the right to rescind their loans en masse, with no cap on lender liability. This question has split the courts, and an upcoming decision expected from the 7th U.S. Circuit Court of Appeals in Chicago could determine whether the issue eventually reaches the U.S. Supreme Court.

Subprime Mortgage Lending

During the housing boom earlier in this decade, adjustable-rate, interest-only and no-documentation loans enabled nontraditional borrowers to become first-time homeowners or to tap into the equity of their existing homes. In 2004, for example, nearly half of all mortgages issued had adjustable rates. Today, foreclosures and defaults—including early payment defaults in the first six months of a loan—are surging among subprime borrowers as interest rates rise and home values fall.

In response, investors are backing away from the subprime market, while the government prepares to intervene. Freddie Mac announced that it would no longer buy bonds backed by subprime mortgages unless the borrowers can make payments at the loan’s maximum rates, not just the low initial rates. Federal banking regulators have proposed requiring lenders to consider subprime applicants’ ability to pay back the entire loan (including higher interest payments as rates adjust upward), and to verify applicants’ incomes. Congressional lawmakers, meanwhile, plan to introduce legislation that would tighten restrictions on lenders and open new avenues of recovery for borrowers. For example, one contemplated bill would bar loans worth more than the value of the collateral—and would impose liability not just on the original lender, but also on the investors who buy and sell the loans as mortgage-based bonds on the secondary markets.

Relief for Subprime Borrowers under TILA

Many subprime borrowers have already pursued relief under TILA, claiming that they were not fully informed of all material loan terms, particularly those related to adjustable interest rates. TILA was enacted in 1968 to "assure the meaningful disclosure of credit terms" and "avoid the uninformed use of credit." TILA requires lenders to make preliminary disclosures to prospective borrowers about the terms of the loan, and it governs both the substance and form of those disclosures. For example, and of particular importance to subprime borrowers, lenders must disclose certain information about adjustable-rate loans— including the existence of the variable rate, when the rate change is to take effect and an estimated composite annual percentage rate that accounts for future increases. All required disclosures must be "clear and conspicuous," which includes being properly grouped and segregated.

A lawsuit brought under TILA typically alleges that required information about the loan was not properly disclosed because mandated content was missing, misleading or confusing. In the subprime context, borrowers allege that they were not adequately informed about when and how much interest rates would rise with their adjustable-rate mortgage. Such borrowers claim that they understood that the low introductory rate would stay fixed for a longer period and would not rise so high or so quickly.

Money Damages and Rescission under TILA

Two types of relief are available to borrowers under TILA: money damages and rescission. The statute’s money damages provision caps the amount of recovery in both individual and class actions. The plaintiffs’ total recovery in a class action may not exceed the lesser of $500,000, or 1 percent of the lender’s net worth.

Borrowers also may rescind their loan for any reason within three days of closing, and certain TILA violations extend the right to rescind to within three years of closing. Rescission unwinds the loan entirely and requires the lender to surrender all loan fees, including interest payments. Violations that extend the rescission period include a lender’s failure to disclose properly the right to rescind or to make certain "material disclosures," such as those regarding the annual percentage rate, any variable rate and the payment schedule. Rescission has been described as a "private" and "personal" remedy to be addressed between lender and borrower. A borrower who wishes to rescind must formally notify the lender of her preference, and the lender has 20 days to respond. A suit can commence only if the parties cannot agree on rescission.

Unlike the TILA provision governing money damages, the statutory section providing for rescission does not impose a cap and does not address class actions. Borrowers’ counsel interpret this silence as authority to seek classwide declarations of rescission rights following TILA violations, placing any given lender at risk of being forced to return unlimited loan fees and interest payments. Lenders’ counsel, in contrast, understand this absence of direction to mean that Congress never intended rescission to be a classwide remedy, much less one with no limit on liability. That question split two federal courts earlier this year.

Judicial Split on Classwide Rescission under TILA

In McKenna v. First Horizon Home Loan Corporation, the 1st U.S. Circuit Court of Appeals in Boston held that classwide rescission claims are not available under TILA. There, the plaintiff borrowers had engaged in home refinancings and claimed they had not been properly informed of their rescission rights, thus extending the rescission period to three years post-closing. The plaintiffs sought a judicial declaration that every class member had the right to rescind his or her loan during this extended period. The 1st Circuit rejected these claims, holding that it was "nose-on-the-face-plain" that allowing classwide rescission claims "would open the door for vast recoveries" that Congress had never intended.

The 1st Circuit gave four reasons for its ruling. First, the court explained that the absence of any mention of class actions in the TILA provision governing rescission—in direct contrast to the provision addressing money damages—"strongly suggests that Congress did not include a class action mechanism." Second, the court rejected the notion that Congress would impose a cap on money damages in class actions but would allow for unchecked classwide rescission claims. In the case at hand, the lender claimed that its potential liability with unrestricted classwide rescission could reach $200 million, while the court estimated the potential exposure at $4.45 million—either way, far above the $500,000 cap on classwide money damages. Third, the 1st Circuit cited the TILA amendments of 1995, in which Congress reacted to another court’s decision by imposing a moratorium on class actions for minor or technical TILA violations. The 1st Circuit noted that while debating this amendment, members of Congress had made clear their desire to avoid "wholesale rescissions" that could bring "financial disaster in the mortgage industry." Finally, the 1st Circuit stressed the private and personal nature of rescission, in which borrower and lender were to attempt to resolve before resorting to filing suit. The court deemed this process "incompatible" with class actions and noted that borrowers had an array of remedies to obtain redress and bring about TILA compliance.

The 1st Circuit’s decision in McKenna came just two weeks after a federal district court in Wisconsin had reached the opposite conclusion. In Andrews v. Chevy Chase Bank, FSB, the court certified a class of borrowers seeking a declaration of their rescission rights. There, the plaintiffs were subprime borrowers who took out an adjustable-rate mortgage to refinance their home. They claimed that the lender had led them to believe that the interest rate was fixed for five years and would adjust upward only thereafter. Instead, although the minimum monthly payment was fixed for five years, the interest rate began to increase after the very first payment—such that only the first month was at the low, "teaser" rate of 1.95 percent. As the interest rate rose, the required minimum monthly payment covered less and less of the debt. Eventually, it would not cover even the accrued interest, so that the principal balance could actually increase over time. The plaintiffs claimed that none of these terms had been properly disclosed under TILA and sought to represent a class of borrowers with a declared right to rescind their loans.

The district court granted this request and so joined the ranks of courts that interpreted TILA’s silence on classwide rescission as tacitly granting authority to proceed. Unlike the 1st Circuit, the district court did not find the difference between TILA’s money damages and rescission provisions to be compelling, concluding that "it is just as likely that Congress did not intend to limit rescission claims in any way." The court also opined that the purpose of class actions—"providing compensation in cases involving public wrongs and widespread injuries"—applied equally in the TILA rescission context.

After the 1st Circuit issued its decision in McKenna, the district court in Andrews agreed to stay its order on class certification pending appeal to the 7th U.S. Circuit Court of Appeals in Chicago. Still, the district court held fast to its ruling that TILA does not prohibit classwide rescissions claims, asserting: "The language of TILA is plain. It does not bar courts from certifying classes whose members have a right to rescind. Nor is the absence of such a bar absurd." The court explained that "it is just as likely that Congress remained silent about class actions involving the right of rescission because it did not regard such actions as posing the same economic threat to the credit industry as class actions involving damages or because it never considered the issue." The court noted that even the 1995 TILA amendments "did not bar class actions involving the right of rescission." Instead, Congress had sought to limit lender liability "by means other than prohibiting courts from certifying classes whose members may seek rescission." Finally, the district court concluded that the "personal nature" of rescission did not preclude a classwide order that merely declared the right to rescind, still allowing for the actual remedy to be privately addressed between borrower and lender. Nonetheless, recognizing the importance of the issue, the district court stayed its order pending appeal, and the 7th Circuit is expected to rule later this year.

Looking Ahead

If the 7th Circuit reverses the district court in Andrews, then every court of appeals to consider the issue will have held that TILA prohibits classwide rescission claims, thus shielding lenders from the prospect of being forced to surrender unlimited loan fees and interest payments en masse. But if the 7th Circuit affirms, lenders could face even greater risk as rising foreclosure rates lead more and more subprime borrowers to court. In that event, it is possible that the U.S. Supreme Court would step in to resolve the issue and, at the very least, establish a uniform set of conditions nationwide.